Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Optimal (Re)insurance Contract Design

Part V: Index Insurance Design

Chengguo Weng
Department of Statistics and Actuarial Science
University of Waterloo

READI Research Workshop - Module 2

Feb 22, 2019

February 9, 2019
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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Outline

Introduction

Model Setup and Main Results

An Example — Weather Index Insurance

Concluding Remarks

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Introduction

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Index Insurance
• Loss-indemnifying insurance:
The indemnity is determined based on the actuarial loss
•
incurred on the policyholders.
• Index-Indemnifying insurance (or simply index insurance):
• The indemnity is determined by a relevant index rather
than actual losses experienced by policyholders.
• Let X be certain index variable utilized in an index insurance
and Y be the actual loss variable for the policyholders.
• Loss-indemnifying insurance pays I (Y ) for certain
function I .
• Index-indemnifying insurance pays I (X ) for certain
function I .
• Applications:
• Barnett and Mahul (2007); Chatarat et al. (2007, 2013);
Bokusheva et al. (2016); International Fund for Agricultural
Development Word Food Program (2010); Conradt et al. (2015);
Carter et al. (2016); Cummins et al. (2004).
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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Index Insurance: Pros

• Index insurance enjoys many desirable features:

• Almost no moral hazard.

• Very low adverse selection.

• Lower expense in underwriting, damage assessment,

claim settlement and etc.

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Index Insurance: Cons

Challenges for effective index insurance design:

• High basis risk.

• Requiring high technical capacity and expertise.

• E.g., agricultural weather index insurance design calls for
knowledge in meteorology, agriculture, biology, etc.
• Statistical modeling is also sometimes challenging.

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Model Setup
and
Main Results

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Notations and Assumptions

• Y ∈ [a, b]: actual loss variable of the policyholder.

• X ∈ [c, d]: index variable.

• f (x, y ): joint density function of X and Y , continuous and

strictly positive on the domain.
• f (y |x) = f (x, y )/h(x): conditional density of Y given X = x.

• I (X ): indemnity paid to the policyholder.

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Mathematical formulation
The expected utility maximization framework:
(
sup J(I ) := E{U(w + I (X ) − Y − (1 − θ)P)}
I ∈I (1)
s.t. P = γE [I (X )]

• I := {I |I : [c, d] → [0, M] is measurable }.

• M: maximum indemnity covered by the insurance contract.
• U: a strictly concave and non-decreasing utility function.
• w : initial wealth of an insured.
• θ ∈ [0, 1] represents the subsidy level to the insured by a third
party.
• P: premium level.
• γ − 1 > 0: risk loading factor.

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Existence and uniqueness

• Apply the Lagrangian method and characterize the optimal

solution:

 0, for x ∈ S1
I ∗ (x) = M, for x ∈ S2
I (x), for x ∈ S3
 b

where the three sets S1 , S2 and S3 are defined via the function

G (ξ, x) = E U 0 (w + ξ − Y − (1 − θ)P) X = x
 

• Proposition 1
Under certain mild condition, the optimal solution to
problem (1) uniquely exists, up to the equality almost
everywhere.

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Optimal Solution — A Sufficient Condition via ODE

• Proposition 2
∂
Assume that ∂x f (y |x) exits and continuous. If a function
Lb : [c, d] → R solves the following ODE problem:
 dL
dx = F (x, L),
P = γE [(L(X ) ∨ 0) ∧ M] ,

where the function F : [c, d] × R → R is defined by

Rb
U 0 (w + L − y − P) ∂x∂
f (y |x) dy
F (x, L) := − Ra b .
U 00 (w + L − y − P) f (y |x) dy
a
 
Then, L∗ := L(x)
b ∨ 0 ∧ M is the optimal solution to problem (1).
• If the index variable X is independent of the actuarial loss
variable Y , F (x, L) ≡ 0 and thus the optimal indemnification
is a constant.
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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Solutions under Special Utility Functions

• For quadratic utility (U(x) = αx − βx 2 , x ≤ α/(2β)), the
optimal indemnity

I ∗ (x) = [(E[Y |X = x] + η ∗ ) ∨ 0] ∧ M,

where η ∗ is determined by γE[I ∗ (X )] = P.

• For exponential utility (U(x) = − α1 e −αx ), the optimal
indemnity
  
∗ 1  αY ∗
I (x) = ln E[e |X = x] + η ∨ 0 ∧ M,
α

where η ∗ is determined by γE[I ∗ (X )] = P.

The determination of I ∗ becomes a regression problem.

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An Example
—
Weather Index Insurance

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Data and Assumption

• Data: county-level data of rice yield and temperature data in

Jiangsu Province, China during the period from 1992 to 2011.
• Y : the highest
detrended yield
during the sam-
ple period less
the detrended
yield.
• X : the average
temperature
during whole
growing period
(◦ C).
• M = 300 and θ = 0.

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Quadratic Utility: Shape with P

300

P=20
P=40
250
P=60
P=80

200
Indemnity

150

100

50

0
23 23.5 24 24.5 25 25.5 26 26.5 27
Index Value

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Quadratic Utility: Basis Risk

450

440
Basis Risk

430

420

410

400
0
200
50 300
400
500
Premium 100 600 Max Indemnity

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Comparison with linear-type contracts

445 445
Optimal Optimal
Linear Linear
440 440

435 435

430 430
Basis Risk

Basis Risk
425 425

420 420

415 415

410 410

405 405
0 20 40 60 80 100 120 140 0 20 40 60 80 100 120 140
Premium Premium

(a) M=250 (b) M=300

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Multiple Indices Based Insurance

• Our results can be easily generalized to include multiple

indices for the determination of optimal indemnity payment.

• We conducted a numerical example using the temperature

and the precipitation as the two indices for the determination
of indemnity payment.

• The inclusion of the additional precipitation variable

significantly reduces the basis risk.

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Concluding Remarks

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Conclusion

• We established the existence and uniqueness of optimal index

insurance design for a utility based model.

• We obtained analytical expressions of optimal indemnification

function for quadratic and exponential utility functions.

• With some technical assumption we transformed the problem

of optimal index insurance design into an ODE problem.

• We illustrated our theoretical results via a real-data based

example.

• Our results are readily applicable to include multiple indices

for the design of index insurance.

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Future Work

• Variants of objective function (e.g., risk measure)

• Variants of constraints (e.g., other premium principles)

• Variable selections for index induces (taking into account the

statistical estimation error)

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Thank You

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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Reference I
[1] Barnett, B. J., & Mahul, O. (2007). Weather index insurance for agriculture and
rural areas in lower-income countries. American Journal of Agricultural
Economics, 89(5), 1241-1247.
[2] Bokushevaa, B., Koganb, F., Vitkovskayac, I., Conradta, S., & Batyrbayevaca M.,
(2016). Satellite-based vegetation health indices as a criteria for insuring against
drought-related yield losses. Agricultural and Forest Meteorology, 220, 200-206.
[3] Burden, R.L., and Faires, J.D. (2011). Numerical Analysis. 9th edition.
Brooks/Cole, Boston, USA.
[4] Carter, M.R., Cheng L., & Sarris, A., (2016). Where and how index insurance
can boost the adoption of improved agricultural technologies. Journal of
Development Economics, 118, 59-71.
[5] Carter, M.R., de Janvry, A., Sadoulet, E., Sarris, A., (2014). Index-based weather
insurance for developing countries: a review of evidence and a set of propositions
for up-scaling. FERDI Working Paper 112.
[6] Chantarat, S., Barrett, C. B., Mude, A. G., & Turvey, C. G. (2007). Using
weather index insurance to improve drought response for famine prevention.
American Journal of Agricultural Economics, 89(5), 1262-1268.
[7] Chantarat, S., Mude, A. G., Barrett, C. B., & Carter, M. R. (2013). Designing
indexbased livestock insurance for managing asset risk in northern Kenya.
Journal of Risk and Insurance, 80(1), 205-237.
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Reference II
[8] Chi, Y., & Weng, C., (2013). Optimal reinsurance subject to Vajda condition.
Insurance: Mathematics and Economics, 53(1), 179-189.
[9] Conradt, S., Finger, R., Sporri, M., (2015). Flexible weather index-based
insurance design. Climate Risk Management, 10, 106-117.
[10] Cummins, J. D., Lalonde, D., & Phillips, R. D. (2004). The basis risk of
catastrophic-loss index securities. Journal of Financial Economics, 71(1), 77-111.
[11] Dana, R. A., & Scarsini, M. (2007). Optimal risk sharing with background risk.
Journal of Economic Theory, 133(1), 152-176.
[12] Doherty, N.A., & Schlesinger, H., (1983). Optimal Insurance in Incomplete
Markets. Journal of Political Economy, 91(6), 1045-1054.
[13] Elabeda, G., Bellemareb, M.F., Carter, M.R., & Guirkinger, C. (2013). Managing
basis risk with multiscale index insurance. Agricultural Economics, 44, 419-431.
[14] Giné, X., Townsend, R., & Vickery, J. (2007). Statistical analysis of rainfall
insurance payouts in Southern India. American Journal of Agricultural
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[15] International Fund for Agricultural Development World Food Program (2010).
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agriculture and rural livelihoods. Technical Report.
[16] Jensen, N.D., Barrett, C.B., & Mude, A.G., (2016). Index insurance quality and
basis risk: evidence from northern Kenya. American Journal of Agricultural
Economics, 98(5), 1450-1469.
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Introduction Model Setup and Main Results An Example — Weather Index Insurance Concluding Remarks References

Reference III
[17] Lin, Y., & Cox, S.H. (2008). Securitization of catastrophe mortality risks.
Insurance: Mathematics and Economics, 42(2), 628-637.
[18] Mahul, O. (2000). Optimum crop insurance under joint yield and price risk.
Journal of Risk and Insurance, 67(1), 109-122.
[19] Mahul, O., & Wright, B. D. (2003). Designing optimal crop revenue insurance.
American Journal of Agricultural Economics, 85(3), 580-589.
[20] Miranda, M.J. & Farrin, K.M. (2012). Index Insurance for Developing Countries.
Applied Economic Perspectives and Policy, 34(3), 391-427.
[21] Okhrin, O., Odening, M., & Xu, W. (2013). Systemic weather risk and crop
insurance: the case of China. Journal of Risk and Insurance, 80(2), 351-372.
[22] Raviv, A. (1979). The design of an optimal insurance policy. The American
Economic Review, 69(1), 84-96.
[23] Shi, H., & Jiang, Z., (2016). The efficiency of composite weather index insurance
in hedging rice yield risk: evidence from China. Agricultural Economics, 47(3),
319-328.
[24] Vercammen, J. (2001). Optimal insurance with nonseparable background risk.
Journal of Risk and Insurance, 68(3), 437-447.
[25] Zhuang, S. C., Weng, C., Tan, K.S., & Assa, H., (2015). Marginal
indemnification function formulation for optimal reinsurance. Insurance:
Mathematics and Economics, 67, 65-76.
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