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Actuarial Implications Of Structural Changes In El Niño-Southern Oscillation Index Dynamics

Author

Listed:
  • SHU-LING CHEN

    () (Department of Finance and Cooperative Management, National Taipei University, 151, University Road, Sanxia District, New Taipei City 23741, Taiwan, R.O.C.)

  • YU-LIEH HUANG

    () (Department of Quantitative Finance, National Tsing Hua University, 101, Sec.2, Kuang-Fu Road, Hsinchu 30013, Taiwan, R.O.C.)

Abstract

The influence of climate variability on agricultural production and financial risks faced by an individual or an institution has been the center of the public discussion in the recent years. The changing weather patterns and environmental conditions could cause substantial unpredicted economic losses. Failure to capture such changes would underestimate the insurance contract's expected indemnity and further create a major obstacle for insurance sectors. In this paper, we undertake a case study of El Niño-Southern Oscillation (ENSO) Index insurance for coastal Peru proposed by Skees. We examined the behavior of El Niño index and uncovered the evidence that the conditional volatility of El Niño index has changed over time. A fractionally integrated GARCH (FIGARCH) process that captures long memory behavior for conditional variance and allows the disturbance variance to vary over time is used to design and rate the ENSO Index insurance contract. Our results show that, with the time-invariant AR(2) model serving as a benchmark, the AR(2)-FIGARCH(1, d, 1) model outperforms the AR(2) model in both in-sample fit and out-of-sample forecast for El Niño index. Moreover, the time-invariant model could underestimate the premium rates, exposing the insurer to undesired underwriting risk and ultimately causing the index insurance market to collapse.

Suggested Citation

  • Shu-Ling Chen & Yu-Lieh Huang, 2014. "Actuarial Implications Of Structural Changes In El Niño-Southern Oscillation Index Dynamics," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 9(02), pages 1-20.
  • Handle: RePEc:wsi:afexxx:v:09:y:2014:i:02:n:s2010495214400077
    DOI: 10.1142/S2010495214400077
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    References listed on IDEAS

    as
    1. Ferris, John N., 1999. "An Analysis Of The Impact Of Enso (El Nino/Southern Oscillation) On Global Crop Yields," 1999 Annual meeting, August 8-11, Nashville, TN 21517, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    2. Andrew Dlugolecki, 2008. "Climate Change and the Insurance Sector," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 33(1), pages 71-90, January.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Actuarial rating; climate variability; El Niño; fractionally integrated GARCH; index insurance; structural change; G21; G22; Q10; Q14;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • Q10 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture - - - General
    • Q14 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture - - - Agricultural Finance

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