The Viability of Weather-index Insurance in Managing Drought Risk in Rural Australia

Abstract

Agriculture is the trade of rural Australians and managing weather risk have implications for Australian demographics. Consequently, we looked into the strategies farmers adopted to manage their revenue risk due to drought with a focus on wheat farmers. The prospects of managing the challenges of indemnity-based insurance with rainfall index insurance were discussed. We established the relationship between yield and cumulative standardized precipitation indices and concluded that a strong relationship between the rainfall index and yield does not necessarily lead to high hedging efficiency. The hedging efficiency of the product was analyzed using the mean root square loss, conditional tail expectation and certainty equivalence of revenue while the spatial and temporal nature of the risk were captured with loss ratios. It was observed that the inverse relationship between price and yield offsets some risks and reduces the efficiency of weather hedges. Differences were observed in the hedging efficiency across locations and efficiency was noted to be dependent on the methodology adopted. The results from the loss ratio analysis showed that pooling insurance contracts reduced risk to the insurer. We concluded that other variables would have to be taken into consideration in order to make the design of weather-index insurance more robust and that tax incentives on insurance premium would motivate farmers to be profitable.