Crop price insurance in China: pricing and hedging using futures market

Abstract

PurposeThe purpose of this paper is to demonstrate how crop price insurance premium can be calculated using an option pricing model and how insurers can transfer underwriting risks in the futures market.Design/methodology/approachBased on data from spot and futures market in China, this paper develops an improved B-S model for the calculation of crop price insurance premium and tests the possibility of hedging underwriting risks by insurance firms in the futures market.FindingsThe authors find that spot price of crops in China can be estimated with agricultural commodity futures prices, and can be taken as the insured price for crop price insurance. The authors also find that improved B-S model yields better estimation of crop price insurance premium than traditional B-S model when spot price does not follow geometric Brownian motion. Finally, the authors find that hedging can be one good alternative for insurance firms to manage underwriting risks.Originality/valueThis paper develops an improved B-S model that is data-driven in nature. Insured price of the crop price insurance, or the exercise price used in the B-S model, is estimated from a co-integration model built on spot and futures market price series. Meanwhile, distributional patterns of spot price series, one important factor determining the applicability of B-S model, is factored into the improved B-S model so that the latter is more robust and friendly to data with varied distributions. This paper also verifies the possibility of hedging of underwriting risks by insurance firms in the futures market.