Risk reduction potential of weather index-based insurance in agribusiness-the importance of the aggregation level of yield time series

Abstract

Weather index-based insurance is not sufficiently used in agriculture as of yet. Basis risks are considered to be a major reason for this. By the use of weather index-based insurance, basis risks remain with the farmer. However, weather index-based insurance can be interesting for agribusiness companies, specifically those which aggregate yields of several farms amongst themselves. This paper investigates the importance of the aggregation level of yield time series for the hedging effectiveness of weather index-based insurance following the example of a sugar processing company. This investigation is based on empirical sugar beet yield data from 40 sugar beet producing farms in Northern Germany. Furthermore, we work with the aggregated sugar yield time series of roughly 5,000 farms, which account for sugar beets used in the sugar processing company in question. At the same time, this highly aggregated yield time series describes the quantity risk of the sugar processing company. Our results empirically show that in consequence of aggregating the sugar yield time series, basis risk is diminished and risk reduction potential is raised through the use of weather index-based insurance. The risk reduction potential of weather indexbased insurance can, therefore, be underestimated if it is derived from studies pertaining to yield time series at the individual farm level. The focus of the present study may be relevant for agribusiness companies, as well as for potential providers of weather derivatives.