Managing Weather Risk with a Neural Network-Based Index Insurance

Nanyang Business School Research Paper No. 20-28

78 Pages Posted: 24 Mar 2020 Last revised: 24 Aug 2021

See all articles by Zhanhui Chen

Zhanhui Chen

Hong Kong University of Science & Technology (HKUST) - Department of Finance

Yang Lu

Dept. Maths & Statis, Concordia University

Jinggong Zhang

Nanyang Business School, Nanyang Technological University

Wenjun Zhu

Nanyang Business School, Nanyang Technological University

Date Written: February 17, 2020

Abstract

Weather risk affects economy, agricultural production in particular. Index insurance is a promising tool to hedge against weather risk, but current piecewise-linear index insurance contracts face large basis risk and low demand. We propose embedding a neural network-based optimization scheme into an expected utility maximization problem to design the index insurance contract. Neural networks capture highly nonlinear relationship between the high-dimensional weather variables and production losses. We endogenously solve for the optimal insurance premium and demand. This approach reduces basis risk, lowers insurance premium, and increases farmers' utility. Our approach can be generalized to design other financial products.

Keywords: weather risk; index insurance; basis risk; neural networks; machine learning

JEL Classification: C45, G11, G22, G52, O13, Q54

Suggested Citation

Chen, Zhanhui and Lu, Yang and Zhang, Jinggong and Zhu, Wenjun, Managing Weather Risk with a Neural Network-Based Index Insurance (February 17, 2020). Nanyang Business School Research Paper No. 20-28, Available at SSRN: https://ssrn.com/abstract=3539811 or http://dx.doi.org/10.2139/ssrn.3539811

Zhanhui Chen

Hong Kong University of Science & Technology (HKUST) - Department of Finance ( email )

Clear Water Bay, Kowloon
Hong Kong

Yang Lu

Dept. Maths & Statis, Concordia University ( email )

Blvd. maisonneuve
Montreal, H4R 3B3
Canada

Jinggong Zhang

Nanyang Business School, Nanyang Technological University ( email )

Singapore, 639798
Singapore

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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