Pricing of weather index insurance products

Abstract

Weather index insmance is relatively a new type of risk mitigation mechanism which could assist in alleviating some of the problems like moral hazard and adverse selection that are related with traditional crop insmance schemes. This paper focuses on pricing of weather index insmance products using the option pricing model, the Black-Scholes framework. Pricing of the weather index products responds to objective and independent index parameters. The index parameter is expected to have a strong conelation with the yield loss. The index parameter used in this study was rainfall and the crop yield used was maize. The rainfall data obtained from Kenya Meteorological Department and the maize yield data collected from the Ministry of Agricultme was proven to have a strong conelation. One ofthe assumptions of the BlackScholes framework is that the underlying asset follows a log-n01mal distribution. The underlying asset in this study, rainfall, was proven to be log-normally distributed. This study focused on cases of inadequate rainfall and the payout and premium were calculated. The results show that maize farmers can protect themselves against the effects of inadequate rainfall by purchasing the weather index insurance product.