Weather index‐based insurances for farmers in the North China Plain: An analysis of risk reduction potential and basis risk

Abstract

Purpose

The purpose of this paper is to analyze the extent to which weather index‐based insurances can contribute to reducing shortfall risks of revenues of a representative average farm that produces corn or wheat in the North China Plain (NCP). The geographical basis risk is quantified to analyze the spatial dependency of weather patterns between established weather stations in the area and locations where the local weather patterns are unknown.

Design/methodology/approach

Data are based on the Statistical Yearbook of China and the Chinese Meteorological Administration. Methods of insurance valuation are burn analysis and index value simulation. Risk reduction is measured non‐parametrically and parametrically by the change of the standard deviation and the value at risk of revenues. The geographical basis risk is quantified by setting up a decorrelation function.

Findings

Results suggest significant differences in the potential risk reduction between corn and wheat when using insurance based on a precipitation index. The spatial analysis suggests a potential to expand the insurance around a reference weather station up to community level.

Research limitations/implications

Findings are limited by a weak database in China and, in particular, by the unavailability of individual farm data. Moreover, the low density of weather stations currently limits the examination of the approach in a broader context.

Practical implications

The risk reduction potential of the proposed insurance is encouraging. From a policy point of view, the approach used here can support the adjustment of insurers towards different crops.

Originality/value

This paper is believed to be the first that investigates a weather index‐based insurance designed for an average farm in the NCP and the quantification of geographical basis risk.

Citation

Erec Heimfarth, L. and Musshoff, O. (2011), "Weather index‐based insurances for farmers in the North China Plain: An analysis of risk reduction potential and basis risk", Agricultural Finance Review, Vol. 71 No. 2, pp. 218-239. https://doi.org/10.1108/00021461111152582