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Weather insurance design with optimal hedging effectiveness

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  • Kapphan, Ines

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.

Suggested Citation

  • Kapphan, Ines, 2011. "Weather insurance design with optimal hedging effectiveness," MPRA Paper 35861, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:35861
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    File URL: https://mpra.ub.uni-muenchen.de/35861/1/MPRA_paper_35861.pdf
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    References listed on IDEAS

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    2. Olivier Mahul, 2001. "Optimal Insurance Against Climatic Experience," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 83(3), pages 593-604.
    3. Olivier Mahul, 2000. "Optimum crop insurance under joint yield and price risk," Post-Print hal-01952116, HAL.
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    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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    11. 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.
    12. Olivier Mahul, 2001. "Optimal insurance against climatic experience," Post-Print hal-01952102, HAL.
    13. 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(3), pages 1-17, December.
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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;The Geneva Association, vol. 37(2), pages 286-317, April.

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    More about this item

    Keywords

    agricultural insurance; optimal insurance design; weather derivatives; weather risk; hedging effectiveness; loading of premium;
    All these keywords.

    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

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