Weather insurance design with optimal hedging effectiveness
AbstractI construct index-based weather insurance contracts with optimal hedging effectiveness for the insured or maximal profits for the insurer. In contrast to earlier work, I refrain from imposing functional form assumptions on the stochastic relationship between weather and yield and from restricting attention to (piecewise) linear contracts. Instead, I derive the shape of the optimal weather insurance contracts empirically by non-parametrically estimating yield distributions conditional on weather. I find that the optimal pay-off structure is non-linear for the entire range of weather realizations. I measure risk reduction of optimal weather insurance contracts for different weather indices and levels of risk aversion. Considering profit-maximizing contracts, I find that at modest levels of risk aversion (coefficient of relative risk aversion around 2), a loading factor of 10% of the fair premium is possible such that the insurance contract remains attractive for the insured. With higher levels of risk aversion, loading of more than 50% becomes possible.
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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 35861.
Date of creation: 01 Jun 2011
Date of revision:
agricultural insurance; optimal insurance design; weather derivatives; weather risk; hedging effectiveness; loading of premium;
Find related papers by JEL classification:
- Q1 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
This paper has been announced in the following NEP Reports:
- NEP-AGR-2012-01-25 (Agricultural Economics)
- NEP-ALL-2012-01-25 (All new papers)
- NEP-IAS-2012-01-25 (Insurance Economics)
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