Rainfall Intensity and Frequency Explain Production Basis Risk in Cumulative Rain Index Insurance

Abstract

With minimal moral hazard and adverse selection, weather index insurance promises financial resilience to farmers struck by harsh weather conditions through swift compensation at affordable premium. Despite these advantages, the very nature of indexing gives rise to production basis risk as the selected weather indexes do not sufficiently correspond to actual damages. To address this problem, we develop a stochastic yield model, built upon a stochastic soil moisture model driven by marked Poisson rainfall. Our analysis shows that even under similar temperature and rainfall amount yields can differ significantly; this was empirically supported by a 2‐year field experiment in which rain‐fed maize was grown under very similar total rainfall. Here, the year with more intense, less‐frequent rainfall produces a better yield—a rare counter evidence to most climate change projections. Through a stochastic yield model, we demonstrate the crucial roles of rainfall intensity and frequency in determining the yield. Importantly, the model allows us to compute rainfall pattern‐related basis risk inherent in cumulative rain index insurance. The model results and a case study herein clearly show that total rainfall is a poor indicator of yield, imposing unnecessary production basis risk on farmers and false‐positive payouts on insurers. Incorporating rainfall intensity and frequency in the design of rain index insurance can offer farmers better protection, while maintaining the attractive features of the weather index insurance and thus fulfilling its promise of financial resilience.

Sub-Daily Rainfall Intensity Extremes: Evaluating Suitable Indices at Australian Arid and Wet Tropical Observing Sites

“…Therefore, whilst the SDII is a useful index in secular change studies, it provides too little resolution of true intensity for investigating phenomena such as water partitioning at the landsurface [16], and others mentioned above, which have a marked dependence on the actual short-term values of intensity, intermittency, and other rainfall properties that may vary over periods of <<1 h. For instance, [17] observed that the concentration time for many storm events over urban catchments was in the range 15-30 min, and intensities on such timescales must be quantified. Likewise, crop growth is influenced by aspects of the rainfall intensity and frequency, and not merely the accumulated rainfall amount, because of the way in which these affect the entry of water into the root zone [18]. Consequently, [19] noted that "the impact of a rainfall event depends on how it unfolds [that is, on the intensity as it varies from moment to moment] as much as on the final rainfall tally."…”

An Actuarial Pricing Method for Air Quality Index Options

“…People and enterprises both take measures to hedge against the risk created by different forms of extreme weather. For catastrophic weather events, such as tsunamis and severe rainstorms, which cause serious property losses and high casualties, insurance can be used to shift the risk from individuals and enterprises to insurance companies [7,8]. For non-catastrophic weather fluctuations, such as high or low temperatures, rainfall, and other frequent events, the losses are relatively small, but fluctuations in these weather conditions may still have considerable impacts on enterprises that are sensitive to weather.Using derivatives to hedge against the risks created by weather factors can reduce fluctuations in earnings and help a company hedge against risk.…”