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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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    1. 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.
    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. 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.
    4. Olivier Mahul, 2001. "Optimal Insurance Against Climatic Experience," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 83(3), pages 593-604.
    5. 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.
    6. 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.
    7. 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.
    8. Olivier Mahul, 1999. "Optimum Area Yield Crop Insurance," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 81(1), pages 75-82.
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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.

    More about this item

    Keywords

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

    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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