Securitization in crop insurance with soil classification

Abstract

Securitization is an emerging alternative to transfer of insurance risk, especially in cases exceeding the capacity of reinsurance, thus extending the insurability of risks. The original subjects of securitization are the risks emerging from the aftermaths of natural disasters. The range of securitized risks has broaden rapidly over the past decade. The reason of securitization’s feasibility in transfer of agricultural risks is the spatial correlation of harvests among the producers that can result in fatal loss suffered simultaneously by many producers and subsequent producer’s insolvency to settle the insurance claims. The paper proposes the reduction of the insurer’s risk exposure by its transfer to capital markets via catastrophe bonds. A catastrophic event is defined through the relative loss of the current national per hectare yield of the particular crop to the average yield from previous years. The number of years included in the average is subject to the minimization of the relative loss’ fluctuation over the given period. The triggering probability of the catastrophe bond is calculated from the kernel estimation of the loss distribution, with the relative loss being the loss index. The general case is upgraded by the factor of soil quality. The insurer is proposed to offer the coverage according to the producers’ soil. The soil classes are securitized separately, with the set of catastrophe bonds. Both cases are illustrated by the numerical example on the data set of wheat produced in the Slovak Republic over last 45 years. The outcome of the examples are the graphs of expected payoffs depending on various parameters.