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Weather insurance design with optimal hedging effectiveness

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  • Kapphan, Ines
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    Abstract

    I 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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    File URL: http://mpra.ub.uni-muenchen.de/35861/
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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 35861.

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    Date of creation: 01 Jun 2011
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    Handle: RePEc:pra:mprapa:35861

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    Related research

    Keywords: agricultural insurance; optimal insurance design; weather derivatives; weather risk; hedging effectiveness; loading of premium;

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    1. Vedenov, Dmitry V. & Barnett, Barry J., 2004. "Efficiency of Weather Derivatives as Primary Crop Insurance Instruments," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 29(03), December.
    2. Jerry R. Skees & J. Roy Black & Barry J. Barnett, 1997. "Designing and Rating an Area Yield Crop Insurance Contract," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 79(2), pages 430-438.
    3. Olivier Mahul & Brian D. Wright, 2003. "Designing Optimal Crop Revenue Insurance," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 85(3), pages 580-589.
    4. Olivier Mahul, 1999. "Optimum Area Yield Crop Insurance," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 81(1), pages 75-82.
    5. Barry K. Goodwin, 2001. "Problems with Market Insurance in Agriculture," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 83(3), pages 643-649.
    6. Olivier Mahul, 2001. "Optimal Insurance Against Climatic Experience," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 83(3), pages 593-604.
    7. Martin, Steven W. & Barnett, Barry J. & Coble, Keith H., 2001. "Developing And Pricing Precipitation Insurance," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 26(01), July.
    8. Oliver Musshoff & Martin Odening & Wei Xu, 2009. "Management of climate risks in agriculture-will weather derivatives permeate?," Applied Economics, Taylor & Francis Journals, vol. 43(9), pages 1067-1077.
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    Cited by:
    1. Ines Kapphan & Pierluigi Calanca & Annelie Holzkaemper, 2012. "Climate Change, Weather Insurance Design and Hedging Effectiveness," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan, vol. 37(2), pages 286-317, April.

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