Diversifying systemic risk in agriculture

Abstract

Purpose Portfolio risk in crop insurance due to the systemic nature of crop yield losses has inhibited the development of private crop insurance markets. Government subsidy or reinsurance has therefore been used to support crop insurance programs. The purpose of this paper is to investigate the possibility of converting systemic crop yield risk into “poolable” risk. Specifically, this study examines whether it is possible to remove the co-movement as well as tail dependence of crop yield variables by enlarging the risk pool across different crops and countries. Design/methodology/approach Hierarchical Kendall copula (HKC) models are used to model potential non-linear correlations of the high-dimensional crop yield variables. A Bayesian estimation approach is applied to account for estimation risk in the copula parameters. A synthetic insurance portfolio is used to evaluate the systemic risk and diversification effect. Findings The results indicate that the systemic nature – both positive correlation and lower tail dependence – of crop yield risks can be eliminated by combining crop insurance policies across crops and countries. Originality/value The study applies the HKC in the context of agricultural risks. Compared to other advanced copulas, the HKC achieves both flexibility and parsimony. The flexibility of the HKC makes it appropriate to precisely represent various correlation structures of crop yield risks while the parsimony makes it computationally efficient in modeling high-dimensional correlation structure.