Hedging effectiveness of weather index-based insurance in China

Abstract

Purpose

Maize production in China is exposed to pronounced yield risks, in particular weather risk, which is one of the most important and least controllable sources of risk in agriculture. The purpose of this paper is to analyze the extent to which weather index-based insurance can contribute to reducing the revenue risk in maize production caused by yield variations. An average farm producing maize is analyzed for each of eight Chinese provinces, six of which are part of the Northern Plains of China.

Design/methodology/approach

Data are based on the Statistical Yearbook of China and the Chinese Meteorological Administration. The used method of insurance pricing is burn analysis. Hedging effectiveness of precipitation index-based insurance is measured by the relative reduction of the standard deviation (SD) and the Value at Risk of maize revenues.

Findings

Results reveal that precipitation index-based insurance can cause a reduction of up to 15.2 percent of the SD and 38.7 percent of the Value at Risk with a 90 percent confidence level of maize revenues in the study area. However, there are big differences in the hedging efficiencies of precipitation index-based insurance measured at different weather stations in the various provinces. Therefore, it is recommended for insurance providers to analyze the hedging effectiveness of weather index-based insurance with regard to the geographical location of their reference weather station if they would like to offer weather index-based insurance products.

Research limitations/implications

The absence of individual, long-term yield data in the study area prevents the evaluation of risk on individual farms. Thus, the hedging effectiveness can only be analyzed on an aggregated level of yield data and can rather be modeled for an average farm of a particular province.

Originality/value

To the author's knowledge, this paper is the first that investigates the hedging effectiveness of precipitation index-based insurance designed for reducing revenue risk of maize production in eight Chinese provinces.

Citation

Pelka, N., Musshoff, O. and Finger, R. (2014), "Hedging effectiveness of weather index-based insurance in China", China Agricultural Economic Review, Vol. 6 No. 2, pp. 212-228. https://doi.org/10.1108/CAER-11-2012-0124