Hedging of a Portfolio of Rainfall Insurances using Rainfall Bonds and European Call Options (Bull Spread)
Southwestern Finance Association (SWFA) 2017 Little Rock Meetings Paper
29 Pages Posted: 12 May 2016 Last revised: 2 Sep 2017
Date Written: March 9, 2017
Securitization of the rainfall risk involves pooling of the rainfall contingent insurance policies to issue financial instruments in the capital markets to transfer the rainfall risk from the insurers to the investors. Low income households, especially in the developing countries like India could suffer losses due to weather related events such as drought, hurricanes, floods etc. Such losses could cast an agri-household into a chronic poverty cycle - a poverty trap from which the household may find it difficult to re-emerge. India has implemented a country wide rainfall based insurance cover to compensate the agri-households based on the weather outcome. But the pooled rainfall risk in a rainfall insurance portfolio is currently carried by the state owned insurers. In this work, we propose a methodology to securitize the rainfall risk and transfer it to the capital markets by issuing the rainfall bonds or European type rainfall call options with an upper limit to the investors. We first model the multivariate rainfall distribution using a t copula and then price a portfolio of rainfall insurances for two crops in three districts each. We then estimate the parameters of rainfall bond and rainfall call option with upper limit by minimizing the variance and value at risk (VaR) of the hedged portfolio of financial instrument and rainfall insurances.
We find that the risk measures such as variance and value at risk (VaR) of a hedged portfolio consisting of the rainfall insurances and the financial instruments issued in the capital markets are lower than the risk measures of an unhedged portfolio consisting of only rainfall insurances. In our example the Rainfall call options were more effective at mitigating the rainfall risk than the rainfall bonds and the capital requirement for an effective hedging of the rainfall insurance portfolio was much higher for the rainfall bonds than that for the rainfall call options.
Keywords: Securitization, weather derivatives, rainfall insurance in India, CAT bonds, rainfall call options, t Copulas, Monte Carlo simulations, value at risk (VaR), optimization, pricing in incomplete markets
JEL Classification: G13, G17, G22, Q14
Suggested Citation: Suggested Citation