Applying Black Scholes method for crop insurance pricing

Abstract

Uncertainty of weather can cause a lot of problems, especially to crop industry that depends on weather. Excessive or lack of rainfall can cause crop failure and hence the farmers will suffer from it. Crop failure can be considered as risk for farmers. Therefore, insurance is needed to manage the risk. There is similar characteristic between insurance and put options. Options value can be obtained from Black-Scholes method. The Black-Scholes method can be used for calculating insurance premiums. To apply the Black-Scholes method, rainfall and harvest area data are used. This paper will focus on crop insurance pricing based on rainfall and the risk used is drought, so the benefit will be paid if the rainfall is lower than the triggered rainfall. The amount of crop insurance premium will be greater if the triggered parameter increase.