Viability of weather index insurance in managing drought risk in Australia

In this paper, we look into the risk management strategies adopted by farmers to manage revenue shortfall resulting from drought-induced yield losses. We survey literature on traditional indemnity–based insurance and weather index insurance. Some challenges facing the indemnity-based insurance were discussed and the prospects of resolving these challenges by using an index based risk transfer product called weather index insurance was analysed. The particular weather variable of interest was rainfall. Basis risk and methodological challenges were recognized as some of the major challenges to the uptake of weather index insurance. We showed the relationship between yield and cumulative precipitation indices using regression analyses. The hedging efficiency of the product was analysed using the Mean Root Square Loss (MRSL) and Conditional Tail Expectation (CTE) while the systemic nature of the risk was captured with Loss Ratios. We concluded that a strong relationship between the rainfall index and yield does not necessarily lead to high hedging efficiency and other variables would have to be taken into consideration in order to make the design of weather index insurance more robust. We found that the MRSL is more resistant to strike levels of the contracts than the CTE. The results from the Loss Ratio Analysis showed that spatial and temporal pooling of insurance contracts reduce the risk to the insurer.