The working group on risk management in
Production/Weather Risk Management
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| 2.3.2.1. Production/Weather Risk Management Insurance is another formal mechanism used in many countries to share production risks. However, insurance is not as efficient in managing production risk as derivative markets are for price risks. Price risk is highly spatially correlated and, as illustrated by Figure-1 below futures and options are appropriate instruments to deal with spatially correlated risks. In contrast, insurance is an appropriate risk management solution for independent risks. Agricultural production risks typically lack sufficient spatial correlation to be effectively hedged using only exchange-traded futures or options instruments. At the same time, agricultural production risks are generally not perfectly spatially independent and therefore insurance markets do notwork at their best. Experts refer to these risks as “in-between” risks. According to economists, good or bad weather may have similar effects on all farmers in adjoining areas and, consequently, the law of large numbers, on which premium and indemnity calculations are based, breaks down In fact, positive spatial correlation in losses limits the risk reduction that can be obtained by pooling risks from different geographical areas. This increases the variance in indemnities paid by insurers. In general, the more the losses are positively correlated, the less efficient traditional insurance is as a risk-transfer mechanism. |