Climate Change, Weather Insurance Design and Hedging Effectiveness

The insurance industry has so far relied on historical data to develop and price weather insurance contracts. In light of climate change, we examine the effects of this practice in terms of the hedging effectiveness and profitability of insurance contracts. We use simulated crop and weather data for today’s and future climatic conditions to derive optimal weather insurance contracts. We assess the hedging effectiveness and profits of adjusted contracts that are designed with data that accounts for the changing distribution of weather and yields due to climate change. We find that, with climate change, the benefits from hedging with adjusted contracts almost triple and expected profits increase by about 240%. Furthermore, we investigate the effect on risk reduction (for the insured) and profits (for the insurer) from hedging future weather risks with non-adjusted contracts, which are based on historical weather and yield data. When offering non-adjusted insurance contracts, we find that insurers either face substantial losses, or generate profits that are significantly smaller than profits from offering adjusted insurance products. Non-adjusted insurance contracts that create profits in excess of the profits from adjusted contracts cause at the same time negative hedging benefits for the insured. We observe that non-adjusted contracts exist that create simultaneously positive profits and hedging benefits, however at a much larger uncertainty compared to the corresponding adjusted contracts.