Improved Index Insurance Design and Yield Estimation Using a Dynamic Factor Forecasting Approach

33 Pages Posted: 27 Jun 2018 Last revised: 12 Jan 2021

See all articles by Hong Li

Hong Li

Warren Centre for Actuarial Studies and Research, University of Manitoba

Lysa Porth

University of Manitoba - Warren Centre for Actuarial Studies and Research; University of Waterloo - Department of Statistics and Actuarial Science; University of Manitoba - Department of Agribusiness and Agricultural Economics

Ken Seng Tan

University of Waterloo

Wenjun Zhu

Nanyang Business School, Nanyang Technological University

Date Written: May 9, 2018

Abstract

Accurate crop yield forecasting is central to effective risk management for many stakeholders, including farmers, insurers, and governments, in various practices, such as crop management, sales and marketing, insurance policy design, premium rate setting, and reserving. This paper rst investigates an innovative approach of yield forecasting using a dynamic factor model. Based on the proposed approach, we then design an enhanced weather index-based insurance (IBI) policy. The dynamic factor approach is motivated by its ability to effectively summarize the information in a large set of explanatory variables with common factors of a much lower dimension. This makes it possible to use an extensive set of variables in crop yield prediction without worrying about identication issues. Using both county-level and state-level crop production data from the state of Illinois, U.S., the empirical results show that the dynamic factor approach produces more accurate in- and out-of-sample forecasting results compared to the classical statistical models. The empirical results also support that the proposed IBI policy based on the dynamic forecasting model has small basis risk. This, in turn, greatly improves the IBI's hedge effectiveness against agricultural production as well as increases its practicality as an insurance policy for agriculture.

Keywords: Crop Yield Forecasting; Factor Model; Index-Based Insurance

Suggested Citation

Li, Hong and Porth, Lysa and Tan, Ken Seng and Zhu, Wenjun, Improved Index Insurance Design and Yield Estimation Using a Dynamic Factor Forecasting Approach (May 9, 2018). Insurance: Mathematics and Economics, 96, 208-221, Available at SSRN: https://ssrn.com/abstract=3195396 or http://dx.doi.org/10.2139/ssrn.3195396

Hong Li

Warren Centre for Actuarial Studies and Research, University of Manitoba ( email )

638 Drake Centre, 181 Freedman Crescent
Winnipeg, MB R3T 2N2
Canada

HOME PAGE: http://https://hongliecon.weebly.com/

Lysa Porth

University of Manitoba - Warren Centre for Actuarial Studies and Research ( email )

638 Drake Centre, 181 Freedman Crescent
Winnipeg, MB R3T 2N2
Canada

University of Waterloo - Department of Statistics and Actuarial Science ( email )

Waterloo, Ontario N2L 3G1
Canada

University of Manitoba - Department of Agribusiness and Agricultural Economics ( email )

Winnipeg, MB, R3T 2N2
Canada

Ken Seng Tan

University of Waterloo ( email )

Waterloo, Ontario N2L 3G1
Canada

Wenjun Zhu (Contact Author)

Nanyang Business School, Nanyang Technological University ( email )

50 Nanyang Avenue
Singapore, 639798
Singapore
(65) 6592-1859 (Phone)

HOME PAGE: http://sites.google.com/view/wenjun-zhu

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