Improving the Effectiveness of Weather-based Insurance: An Application of Copula Approach

The study develops the methodology for a copula-based weather index insurance rating. As the copula approach is better suited for modeling tail dependence than the standard linear correlation method, we suppose that copulas are more adequate for pricing a weather index insurance contract against extreme weather events. To capture the dependence structure in the left tail of the joint distribution of a weather variable and the farm yield, we employ the Gumbel survival copula. Our results indicate that, given the choice of an appropriate weather index to signal extreme drought occurrence, a copula-based weather insurance contact might provide higher risk reduction compared to a regression-based indemnification.