AGRICULTURAL

ECONOMICS
Agricultural Economics 47 (2016) 319328

The efficiency of composite weather index insurance in hedging rice yield

risk: evidence from China
Hong Shia, , Zhihui Jiangb
a School

of Public Affairs, Zhejiang University, 866 Yuhangtang Rd, Hangzhou, Zhejiang 310058, China
b RSFAS, Australian National University, Australia

Received 21 September 2014; received in revised form 7 September 2015; accepted 22 December 2015

Abstract
As an economic and market-transparent program, weather index insurance is expected to mitigate asymmetric problem. Capturing the relationship
between yield and weather factor(s) is the basis of index insurance, but remains a challenge for weather index schemes. Meanwhile, composite
weather index insurance is needed by farmers when their agricultural activities involve several risks, but is rarely studied. We aim to design a
composite weather index insurance model and evaluate its efficiency in hedging yield risk by using the case of rice production in China. We divide
the whole growth cycle of rice into six stages on the basis of agronomic knowledge, and use the average value of each weather factor in each stage
to design a weather index. Then, the efficiency of composite weather index insurance is evaluated by mean-semivariance and value-at-risk methods.
First, we find that subdivision of the growth cycle helps to better capture the subtle relationship between rice yield and weather factors. Second,
composite weather index insurance evidently reduces yield risk. Our findings help further adoption of weather index insurance in agricultural fields.
JEL classifications: Q14, G22
Keywords: Composite Weather Index Insurance; Risk Hedging; Efficiency

1. Introduction
Crop insurance has been widely adopted across the world as
a risk management tool. However, traditional crop insurance
schemes have suffered severe moral hazard (Coble et al., 1997)
and heavy loss investigation expenses. The efficiency of traditional crop insurance has been questioned and it is deemed
necessary to reconsider the scope and use of such schemes
(Makki, 2002). Miranda and Glauber (1997) have argued that
systemic risk, not asymmetric problems, may pose more serious obstacles to the private crop insurance market. Alternative
agricultural insurance schemes have been suggested. Among
these, weather index insurance has received a great deal of attention. Since index contracts are designed to provide efficient
Corresponding author. Tel.: 86-571-88273130. E-mail address: shihong919@126.com (Hong Shi).

Data Appendix Available Online

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C

2016 International Association of Agricultural Economists

means of risk transfer rather than risk pooling, systemic risk

is no longer a problem. Index contracts work even better when
the risk being transferred is somewhat systemic (Vedenov and
Barnett, 2004). As index insurance claim payments are determined by certain indexes rather than individual loss, the problems of moral hazard and adverse selection are also minimized
(World Bank, 2005). Weather index insurance is regarded as
cost-saving and market-transparent. Weather index instruments
have been piloted in some developed countries, such as Canada,
and in several developing countries, such as India, Malawi, and
Morocco with the technical support of the World Food Program and the International Fund for Agricultural Development
(Gine et al., 2010; Meze-Hausken et al., 2009; Stoppa and Hess,
2003).
The attractive properties of weather index insurance have motivated fruitful researches in this area. Some researchers have
focused on developing an actuarially fair price mechanism for
index contracts (Miranda and Vedenov, 2001; Taib and Benth,
2012) and institutional frameworks that would be required to
introduce weather-based insurance (Patt et al., 2009; Vedenov and Barnett, 2004). Meanwhile, many have contributed
to evaluating the potential performance of index contracts in
reducing risk exposure. Stoppa and Hess (2003) used rainfall

DOI: 10.1111/agec.12232

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H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

data for Morocco in designing insurance to evaluate the efficiency of weather derivatives in agricultural application. Deng
et al. (2007) designed the temperature humidity index (THI)
to hedge dairy losses by using long time series of dairy production statistics. Their empirical results showed that index
contracts had a considerable effect on reducing risks. On the
other hand, basis risk is problematic for both farmers and insurers. Van Asseldonk (2003) pointed out that the efficiency
of weather derivatives is largely determined by spatial basis
risk.
A variety of methods are used to evaluate the potential risk
reduction performance of weather index insurance. Vedenov
and Barnett (2004) used the mean root square loss, value-atrisk (VaR), and certainty-equivalent revenues to measure the
change in risk exposure experienced by producers if designed
contracts were purchased. Breustedt et al. (2008) confirmed
statistical reliability by means of bootstrapping when Mean
Variance (MV) and Second order Stochastic Dominance (SSD)
were used to evaluate the risk reduction effect of index insurance. On the basis of a small representative panel data set of
Indian smallholder pepper growers, Zant (2008) simulated the
impact of a joint price and yield index insurance model by
means of the square of the coefficient of variation, with and
without insurance.
These previous weather index insurance models cover one or
two weather factors. But single weather index insurance may
not satisfy the needs of farmers when their agricultural activities
involve several weather risks. Second, the above studies usually
processed weather data as average or accumulated values for
the whole growth duration. However, the timing is as important
as the accumulated or average value of weather factors for
crop yield. The neglect of weather factors distribution prevents
researchers from identifying the subtle relationship between
weather factors and yield.
We aim to design a composite weather index insurance
model and evaluate its risk-reducing effect by focusing on a
case study of Chinese rice production. This extends and improves understanding in two aspects. First, we design a composite weather index insurance model by including all the major
weather factors that significantly affect rice yield. Composite
index insurance will be of greater practical value than singleindex insurance. It is convenient and economic for farmers
who need to be covered against several weather risks. Second, we use subperiod weather data to design a weather index
by dividing the whole rice growth cycle into several phases.
Weather conditions during crops key phases determine grain
yield. Subdivision helps better capture the subtle relationship
between weather factors and yield, which is the basis of index
insurance.
This article is organized as follows. The data and the rice
growth cycle are introduced in Section 2. The weather index
model is discussed in Section 3, followed by the index insurance
design in Section 4. Section 5 evaluates the efficiency of index
insurance in risk hedging. Conclusions and implications are
presented in Section 6.

2. Data and growth cycle

2.1. Data
As the most widely consumed staple food, rice is the agricultural commodity with the third highest worldwide production after sugarcane and maize. China accounts for 29% of
world rice production (USDA, 2014). Rice production is very
important to the Chinese national economy. We examine the
efficiency of weather index insurance with samples of singlecrop late rice in Jiangsu Province, one of Chinas major rice
producing areas. County-level data are used and our sample includes nine rice production areas,1 which together account for
approximately 50% of the provinces total annual production.
Rice yield data are obtained from the Statistical Yearbooks.
Meteorological data come from the China Meteorological Data
Sharing Service System. Temperature, rainfall, sunshine hours,
and relative humidity are believed to be the major weather factors impacting upon rice yield. Daily weather data are collected
from the weather station nearest the center of each rice producing county. The average distance between the center of each
county and weather station is about 35 km. The sample period
is 19912011.
2.2. Subdivision of the growth cycle
According to the Manual for Growth Stages of the Rice
Plant produced by the International Rice Research Institute, the
growth of rice plant is divided into three phases: vegetative (germination to panicle initiation),2 reproductive (panicle initiation
to flowering), and ripening (flowering to mature grain).
The vegetative phase is characterized by active tillering, a
gradual increase in plant height, and leaf emergence at regular
intervals. The length of this phase primarily determines the
duration of cultivars growth. This phase can be subdivided into
three stages: seedling, tillering, and stem elongation. Next, the
reproductive phase that consists of panicle initiation to booting,
heading, and flowering, is characterized by the growth of young
panicles and their upward extension, panicle protrusion from the
sheath, and fertilization. The grain filling and ripening phase
follows fertilization and is characterized by grain growth, which
is the last phase in the development of rice plant.
Rice yield is a complex phenomenon that is directly associated with grain weight, panicle number, and the number of
grains per panicle (Xing and Zhang, 2010). Rice tillering is an
important agronomic trait, as tiller number per plant determines
panicle number, which is a key component of rice yield (Yan
et al., 1998). The rice panicle branching into valid tillers determines the number of panicle-bearing tillers and grain numbers
1 We exclude those counties whose administrative divisions were changed
during the sample period for consistent yield data.
2 In China, most farmers transplant rice seedlings instead of direct seed sowing. Therefore, we divide the growth cycle from seedling though germination
is stage 0 of the whole growth cycle.

H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

per panicle (Liang et al., 2014). Milking determines the grain

weight. Each component differs not only with respect to the
growth stage at which it is determined but also in its relative contribution to grain yield. The component of spikelet per
square meter contributes the most to yield, followed by the filled
spikelet percentage and grain weight together.
Following local agronomists, we divide the whole growth
cycle into six stages: seedling, tiller, shooting, differentiation,
flowering, and ripening. Different rice cultivars have unique
growing durations, which are also affected by regional soil
environment and weather conditions. In the south of Jiangsu
Province, the growing duration of local single-crop late rice
is generally about 170 days. We assume that the duration of
each growth stage remains unchanged across the entire 20-year
periods.3 Table 1 shows the growth cycle of single-crop late
rice in Jiangsu Province.
2.3. Weather effects on rice yield
Rice yield is determined by three component traits: 1) the
number of panicles per unit of land area, 2) the average number
of grains produced per panicle, and 3) the average weight of
individual grains. Therefore, weather conditions in the tillering,
panicle initiation and ripening stages are of great importance
to rice yield. Temperature, rainfall, sunshine hours, and relative humidity are believed to be the major weather factors for
rice yield. Therefore, our explanations for weather effects on
rice yield focus on these four weather factors during the three
stages.
First, as to rainfall, Sreenivasan and Banerjee (1973) found
that rice appeared to respond favorably to rain during the critical phase of panicle primordial initiation, while rainfall in the
period immediately preceding harvest depressed the yield.
Second, high humidity increases the percentage of spikelets
with only a few pollen grains on the stigmas and thus lowers
fertility. Increasing both air temperature and relative humidity significantly increases spikelet sterility, while decreasing
relative humidity decreases high-temperature-induced sterility
(Weerakoon et al., 2008).4
Third, more sunshine hours are favorable for rice yield. Light
intensity and duration affect photosynthesis and carbohydrate
translocation to grains. Sunshine in the grain milking stage
will directly affect the rice yield. Low light has been found to
decrease total biomass, yield, and yield components (Vijayalakshmi et al., 1991).
Lastly, temperature is of great importance in various stages
of rice growth. A higher temperature increases tiller numbers

321

(Yoshida, 1973). Higher temperature at flowering and during

the grain-filling stage reduces yield by causing spikelet sterility
and shortening the duration of the grain-filling phase (Tian
et al., 2007; Xie et al., 2009). Sanchez et al. (2014) studied 140
scientific articles, determined the key temperature thresholds,
and found that the optimal temperature in the tillering stage
was 28.4 C, higher than in other stages, while the grain-filling
stage had the lowest optimal temperature (24.2 C).
2.4. Descriptive analysis of rice yields and weather factors
The rice yields in all nine counties show an increasing trend,
especially during the first and last several years of the sample
period. Fig. 1 shows the rice yield trends of the sample counties
from 1991 to 2011.
The average value of each weather factor during each growth
stage is shown in Table 2. Rainfall shows clear fluctuation from
year to year, especially in the flowering stage. Excessive rainfall
during the flowering period prevents pollination. According to
the temperature thresholds identified by Sanchez et al. (2014),
the average temperatures during the six stages are all in the
normal scale.
3. Weather index model
Rice yield is determined by at least three kinds of factors. The
first kind are factors that fluctuate from year to year, such as
weather factors and fertilizer usage; the second kind are factors
that can be regarded as constant during the sample period, such
as soil quality and landform; the third kind are those that have
improved over time, such as rice variety, planting practices, irrigation equipment, and facilities. In order to capture the effects
of weather factors, we first detrend historical yield by a linear
time regression model:
yieldit = 0 + (t 1991) + it ,

(1)

where yield is the outcome of rice production of each

county; 0 is constant; i denotes rice producing counties
where i = 1, 2, . . . , 9; and (t 1991) represents the influence of factors other than weather on rice yield where t =
1992, 1993, . . . , 2011.
The second step is to regress error term  on weather
variables:
it = 0 +

6


ij t Xij t + it ,

(2)

j =1
3 Though the exact growth duration of each stage may differ each year due
to local weather condition, agricultural experts believe that the difference is
minor. This simplification will not bias our results.
4 For example, in tropical ecosystems, high-temperature-induced grain sterility in rice is already a serious problem. The fertility of rice cultivars is affected by high-temperature stress at flowering. Dry air due to low humidity
promotes dehiscence of anthers and curbs extra elongation of filaments under
high-temperature conditions (Nishiyama and Satake, 1981).

where 0 is constant; j represents each growth stage; Xij t shows

weather variables of county i in stage j of year t, including Rij t ,
RHij t , SHij t , and Tij t that denote rainfall, relative humidity,
sunshine hour, and temperature, respectively. Besides, it stands
for error term, which is also the residual of the whole two-step
regression.

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H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

Table 1
Division of growth cycle
Phase

Stage

Start

End

Duration

I: Vegetative

1. Seedling
2. Tillering
3. Stem Elongation
4. Panicle Initiation to Heading
5. Flowering
6. Ripening

May 15
June 15
July 5
July 25
August 27
September 4

June 14
July 4
July 24
August 26
September 3
October 30

31 days
20 days
20 days
33 days
8 days
57 days

II: Reproductive
III: Ripening

Jiangyin

Yixing

Liyang

Jintan

Kunshan

Wujiang

Taicang

Changshu

Zhangjiagang

Yield per mu

650
600
550
500
450

650
600
550
500
450

650
600
550
500
450
1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010

Year
Fig. 1. Summary of annual average yield in each county.

The Hausman test suggests that a fixed effects model should

be used. The stationarity of the panel data is tested as no unit
root is found. A robust variance estimator is adopted to adjust
standard errors showing heteroscedasticity. Regression results
are given in Table 3. In order to verify the advantage of the sixstage model, we test the same model using both a three-stage
model, as widely used in literature, and a nondivision model,
and find that the three-stage model has R2 of 30.2% in the
second part of the regression, while the R2 of the nondivision
model is only 12.8%.
Regression results show that rainfall has a significant negative
effect on yield in the ripening stage. However, in the panicle
initiation stage (the fourth stage), no significant relationship
is identified between yield and rainfall. Relative humidity has
negative effects on rice yield during the tillering and ripening stages. Increasing relative humidity increases sterility, and
therefore decreases rice yield. Sunshine has a significant positive relationship with rice yield in the ripening stage. Longer
sunshine hours contribute to greater carbohydrate translocation
to grains. In the tillering stage, the amount of sunshine is nega-

tively related to rice yield. Temperature is the main driving force

for rice growth. High temperature affects almost every stage of
rice growth. Higher temperatures are favorable for tillering and
reduce rice yield in the flowering stage, which is consistent with
the report of Yoshida (1973). In summary, the weather regression model functions well in capturing the relationship between
weather factors and rice yield by subdividing the whole growth
period into six stages.

4. Index insurance design

The rice yield for each year can be evaluated by fitting historical weather data into the regression model. We therefore
construct a composite weather index by using these significant
variables, written as
CI =

0 +


0 + j Xj
j Xj
(%) .
100% =
600
6

(3)

H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

323

Table 2
Summary of historical weather factors in each stage
Phases

Stages

Rainfall (mm)

Relative humidity (%)

Sunshine (hours)

Temperature (C)

I: Vegetative

1. Seedling

34.29
(20.16)
90.74
(49.28)
71.34
(49.45)
58.99
(40.31)
45.91
(53.91)
21.88
(9.93)

74.23
(4.69)
81.75
(5.02)
80.70
(4.71)
80.71
(4.18)
81.21
(5.15)
76.50
(3.56)

5.78
(1.09)
4.69
(1.75)
5.99
(2.15)
6.77
(1.95)
5.95
(1.91)
5.58
(0.75)

22.42
(0.88)
25.72
(1.66)
28.07
(1.43)
28.27
(1.15)
26.33
(1.63)
21.28
(4.34)

2. Tillering
3. Stem elongation
II: Reproductive

4. Panicle initiation
to Heading
5. Flowering

III: Ripening

6. Ripening

Note: Weather factors are presented in averages, with standard deviations in parentheses.

Table 3
Outcome of the two-step regression model
Variable

Coefficient

t 1991

2.57***
(0.455)
540***
(6.27)
259
(200)

0
0
Phases
I: Vegetative

Stages
1. Seedling
2. Tillering
3. Stem elongation

II: Reproductive

4. Panicle initiation
to Heading
5. Flowering

III: Ripening

6. Ripening

Rainfall

Relative humidity
2.609***

0.396
(0.244)
0.030
(0.034)
0.052*
(0.007)
0.060
(0.095)
0.012
(0.054)
1.549***
(0.235)

(0.752)
0.865*
(0.441)
1.351**
(0.517)
0.391**
(0.850)
0.074
(0.543)
3.494***
(0.753)

Sunshine

Temperature

3.193
(2.966)
7.944**
(2.799)
4.230
(2.453)
1.726
(2.401)
3.712
(3.316)
11.680*
(5.510)

16.480***
(4.771)
10.980***
(2.486)
0.232*
(5.098)
4.869
(6.455)
5.755**
(2.251)
0.063
(0.166)

Note: 1.* ,** , and *** denote p < 0.1, p < 0.05, and p < 0.01, respectively, with standard errors in parentheses.
2. The variable year explains 14.4% of the total change in yield. After detrending, all the weather variables account for 49.7% of the volatility of residual .
Therefore, the overall R2 = 56.9%.
3. Yield is measured in the unit of kg/mu, where 1 mu = 1/15 hectare. Rainfall is measured in mm, relative humidity in %, sunshine in hours, and temperature in C.

We assume that the influence of weather on rice yield complies with normal distribution and has a zero mean (so that
there is an equal probability of positive or negative effect on
crop yield in different years); therefore, constant 0 is added
to the index for adjustment. Furthermore, with the denominator 600, the proposed index intuitively measures the proportion
of weather yield to a standard level (close to mean value). In
this way, CI reflects the influence of weather conditions on the
harvest, presented as a percentage. In addition, we want the contract to fit all nine counties with a single premium rate, making

it easier to implement in practice. Thus, the spatial indicator i

is omitted here so that only a one-time calculation is required.
Therefore, it is simple to determine the trigger of the insurance contract at zero: when the actual composite index is below
zero, index insurance providers are supposed to pay an insurance indemnity to farmers. Otherwise no indemnity is paid. The
insurance indemnity paid per mu is calculated as

n t =

0
6p CIt

if CIt 0
if CIm CIt < 0,

(4)

Parameter estimation can be done using either parametric

or nonparametric approach. The main difference is that the
parametric method requires sufficiently large amount of data,
and the distribution function must be determined first (sometimes hard to achieve). However, the nonparametric approach
does not require a specific density function, and is therefore
more suitable for small samples (Goodwin and Ker, 1998). In
this article, kernel smoothing is used to estimate yield distribution with Gaussian kernel, details of which are provided in
Appendix A.
4.2. Determining premium rate
The expected losses of crop yield can be evaluated after estimating yield distribution. Theoretically, the actuarially fair
premium rate is the ratio of expected loss to the liability. Together with the estimated loss density f (i), the premium per
mu is expressed as

(5)
= n i f (i) di

=

6p CIi f (i) di .

.08
.02

4.1. Loss distribution

Density
.04
.06

where n t is the indemnity per mu in year t; p is the purchase

price of single-crop late rice, which is assumed to be constant
during the sample period to exclude price risk from our model;5
CIm represents the minimum value of CIt , and the total loss
of the rice insured occurs when CIt = CIm , which is the worst
situation possible. Then, the total indemnity is the product of
unit indemnity per mu and total insured lands.

.1

H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

(6)

324

15

10

10

CI
kernel = Gaussian, bandwidth = 1.2269

Fig. 2. Estimated curve of kernel smoothing.

the curve into small intervals, the summation of the expectation

of each interval converges on the true value. Kernel smoothing
is essentially a form of weighted averaging, so it is possible to
obtain numerous estimated points in order to build up intervals
and to be more precise in approximation.
We choose the minimum protection price of rice in 2012 that
is 1.45 CNY/kg as the market price for conservative purpose,
and assume that the proportional load of premium is 15%.6 The
actuarially fair premium is thus 15.27 CNY/mu and the loaded
premium is 17.57 CNY/mu. The corresponding premium rate
is roughly 2.1% of the monetary value of average yield, which
is 820 CNY/mu, the maximum liability. The uniform premium
rate is of great convenience and an important feature of weather
index insurance (otherwise it would be no different from traditional products for split pricing). When examining policy
efficiency, we still regard each county as a unit.

CIm

5. The efficiency of risk hedging

Meanwhile, the premium rate is in proportion to liability L
(monetary value of standard/mean yield). In practice, a proportional load should be attached to the actuarially fair premium
to cover transaction costs, profit, and reserve-building, so the
loaded premium is defined as (1 + ) .
4.3. The insurance contract
After calculating the historical value of CI and kernel
smoothing estimation, the estimated curve is obtained as shown
in Fig. 2.
To calculate the actuarially fair premium, which is also the
expectation of yield loss, approximation is required since there
is no closed form for the density curve. By indefinitely dividing
5 A farmers rice risk stems from price fluctuation and yield risk. In order
to specify the hedging effect of weather index insurance on yield risk, price is
assumed to be constant.

Next, we evaluate the efficiency of the proposed index insurance in hedging revenue risk. Suppose the investment portfolio
of a farmer consists only of rice production assets and that
he does not purchase the proposed index insurance contract.7
Then, the total revenue R0 can be easily derived by multiplying unit rice price (assumed constant) by annual yield. When
the portfolio includes index insurance, a farmers revenue R1
would be R0 plus the compensation received from the insurance
contract and less loaded premium paid.
6 The proportional load of traditional agricultural insurance is more than 20%
in China. We reduce the load in consideration of the lower expenditure of
weather index insurance in loss investigation and claim settlement.
7 Due to the lack of individual yield data, we regard each county as a decision
maker and evaluate the efficiency of weather index insurance in reducing risks
of each county. However, this county-based analysis may underestimate the
effect of the weather index because the pooling of individual yield risk to
county level lowers yield risk, which leads to less difference of revenue risk
with or without index insurance.

H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

325

Table 4
Revenue with and without contract in each county
County

Revenue without contract

Revenue with contract

Change

Jiangyin
Yixing
Liyang
Jintan
Kunshan
Wujiang
Taicang
Changshu
Zhangjiagang

813.11 (46.27)
797.69 (54.74)
811.46 (73.47)
846.16 (73.25)
807.24 (45.74)
813.37 (37.80)
824.70 (55.90)
831.95 (54.78)
849.05 (46.66)

808.74 (34.77)
796.22 (38.64)
809.99 (61.81)
844.69 (62.53)
802.86 (36.67)
814.25 (32.06)
820.32 (37.87)
827.58 (40.50)
844.67 (28.79)

0.54% (24.8%)
0.18% (29.4%)
0.18% (15.9%)
0.17% (14.6%)
0.54% (19.8%)
+0.11% (15.2%)
0.53% (32.3%)
0.53% (26.1%)
0.52% (38.3%)

Note: Revenues are presented in average, with standard deviations in parentheses.

The revenue and the standard deviation of revenue with and

without an insurance contract are calculated based on historical
observations, and the results are presented in Table 4. It can be
seen that an individuals expected revenue has a slight decrease
after purchasing the insurance contract. Essentially, the difference between the average revenue with and without contract
approximately equals premium loading, as the actuarially fair
premium covers yield losses. The slump of standard deviations
after purchasing the index insurance is particularly noticeable
which is up to nearly 40%, indicating that weather insurance
contracts help reduce revenue fluctuation and smooth farmers
revenue.

ance to test the efficiency of index insurance. Farmers like to be

aware of their revenues in the worst situation, not only the range
of fluctuations. VaR is widely used in measuring the maximum
loss under a specific confidence level of a portfolio caused by
adverse market fluctuations within a specific time frame. The
loss can be written as E(R) R, which simply means loss
occurs when revenue R drops below average.
Table 6 shows the results of VaR estimation. Generally, both
VaR0.95 and VaR0.99 decline after insurance purchase. We believe that the proposed weather index insurance is efficient in
hedging revenue risk.

5.1. The mean-semivariance model

6. Conclusions and implications

Markowitz (1952) proposed the classic mean-variance

principle, which implies that investors judge and weigh the
balance between expected yield and potential risk. Deng et al.
(2007) used a derivative mean-variance model to evaluate the
efficiency of weather index insurance in hedging dairy production losses. However, it is also reasonable to believe that risk
only occurs when yield is below its expected value, known as
downside risk (opposite to upside risk that represents potential benefits).8 Details of the mean-semivariance method are
provided in Appendix B.
Revenue risks with and without a contract at different levels
of k are calculated by using observations in each area. These
results are shown in Table 5. The increased V value after purchasing a contract reveals the positive effect of the proposed
insurance. The rising gap corresponds with the increase of k
indicates that the insurance is of greater importance to those
who are more risk-averse.

Weather index insurance is regarded as an economic and

market-transparent program and has been piloted in some countries, such as Canada, India, and Malawi. However, previous index insurance models only insured against one or two
weather factors. Farmers expect composite weather index insurance when their agricultural activities involve several risks.
Meanwhile, capturing the subtle relationship between weather
factors and yield is always a challenge for the weather index.
We believed that the timing of weather factors is as important
as the accumulated or average value of them for crop yield, and
proposed to subdivide the growth cycle of crops. Single-crop
late rice in Jiangsu Province, China, was used as a sample crop
to construct a composite weather index insurance. Based on
agronomic knowledge, we divided the growth cycle of rice into
six stages. Temperature, rainfall, sunshine hours, and relative
humidity are the major weather factors impacting upon rice
yield and the average value of each weather factor in each stage
is regressed on the detrended rice yield. Test results show that a
six-stage model is much better than both the three-stage model
widely used in the literature and the no division model in capturing the relationship between weather factors and rice yield.
Second, we constructed a composite weather index insurance
for rice and evaluated its risk reducing effect with standard
deviation, mean-semivariance, and VaR methods. Our results
show that a composite weather index insurance is efficient in
hedging revenue risks.

5.2. Value-at-risk
Finally, we investigate the difference of probable minimum
values of revenue with and without the proposed index insur8 So, investors care only about how they may suffer. If performance is above
average, greater deviation means better results, and thus should not be included
in the variance.

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H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

Table 5
Revenue risk with and without a contract at different levels of k
k = 0.1

k = 0.2

k = 0.3

County

V without
contract

V with
contract

V without
contract

V with
contract

V without
contract

V with
contract

Jiangyin
Yixing
Liyang
Jintan
Kunshan
Wujiang
Taicang
Changshu
Zhangjiagang

760.27
696.49
650.06
665.74
759.92
782.72
715.91
742.23
785.61

781.39
750.45
701.30
710.56
773.44
788.52
777.42
780.60
826.36

707.42
595.28
488.66
485.33
712.60
752.07
607.12
652.51
722.18

754.05
704.68
592.61
576.43
744.01
762.80
734.52
733.63
808.05

654.57
494.08
327.26
304.91
665.28
721.41
498.33
562.79
658.75

726.71
658.91
483.92
442.30
714.58
737.07
691.62
686.66
789.74

Note: Revenue risk V is measured by the mean-semivariance model, and k denotes the coefficient of relative risk aversion. Higher (or lower) V corresponds to lower
(or higher) risk exposure.
Table 6
VaR value before and after purchasing insurance given different levels of
= 0.95
County
Jiangyin
Yixing
Liyang
Jintan
Kunshan
Wujiang
Taicang
Changshu
Zhangjiagang

= 0.99

VaR without
contract

VaR with
contract

Change

VaR without
contract

VaR with
contract

Change

84.12
(728.99)
119.96
(677.73)
155.28
(656.18)
171.67
(674.49)
77.92
(729.32)
62.98
(750.39)
134.05
(690.65)
110.65
(721.30)
100.35
(748.70)

58.99
(749.75)
79.05
(717.17)
123.79
(686.20)
143.07
(701.62)
62.03
(740.83)
58.77
(755.48)
76.99
(743.33)
79.34
(748.24)
49.89
(794.78)

25.14
(+20.76)
40.91
(+39.44)
31.49
(+30.02)
28.60
(+27.13)
15.89
(+11.51)
4.21
(+5.09)
57.06
(+52.68)
31.32
(+26.94)
50.46
(+46.08)

108.85
(704.26)
193.91
(603.78)
214.20
(597.26)
221.61
(624.55)
99.34
(707.90)
80.67
(732.70)
195.75
(628.95)
146.33
(685.62)
132.69
(716.36)

70.72
(738.02)
115.12
(681.10)
158.56
(651.43)
193.56
(651.13)
80.01
(722.85)
77.16
(737.09)
123.95
(696.37)
112.82
(714.76)
64.89
(779.78)

38.14
(+33.76)
78.79
(+77.32)
55.64
(+54.17)
28.05
(+26.58)
19.33
(+14.95)
3.51
(+4.39)
71.80
(+67.42)
33.52
(+29.14)
67.80
(+63.42)

Note: A higher (or lower) VaR value corresponds to higher (or lower) risk exposure. denotes confidence level so that Pr(Loss > VaR ) = 1 . Minimum revenues
at certain confidence level are included in parentheses.

Our findings have implications for the further adoption of

weather index insurance in agricultural fields.
First, the method of separating the growth cycle based on
agronomic knowledge can be applied in devising index insurance contracts for other crops. Musshoff et al. (2009) pointed
out that neglecting of the timing of weather factors caused local basis risk. Therefore, a better capture of the relationship
between weather factors and grain yield contributes to the efficiency of weather index insurance in risk reduction.
Second, composite weather index insurance possesses the
advantages of convenience and economy. It is more convenient
than a combination of single-index insurances for farmers who
need multiple risk coverage and the loading cost, which contains
administrative and other costs associated with underwriting an

insurance policy, would be considerably lower than if purchasing separately. Therefore, composite weather index insurance
is a supplement to the existing single-index insurance.
Finally, composite index insurance is of great importance
to countries like China, which face inefficiency problems in
agricultural insurance practice. Because Chinese insurers have
few advanced and economic techniques to mitigate asymmetric
problems, the amount insured in traditional agricultural insurance is too low to cover farmers losses (Shi, 2012). However,
farmers are eager to obtain protection from contracts with sufficient liability. Composite weather index insurance contributes
to Chinese agricultural insurance by solving this dilemma, thus
increasing the efficiency of agricultural insurance in hedging
farmers production risks.

H. Shi, Z. Jiang/ Agricultural Economics 47 (2016) 319328

Nevertheless, it should be noted that composite weather index

insurance increases the complexity of index calculation, which
is considered a drawback. In addition, index insurance will not
be able to help farmers manage idiosyncratic risk. Basis risk
needs to be analyzed before composite weather index insurance
is put into practice. But a certain degree of basis risk has to be
accepted at every level of risk transfer if products are to be both
sustainable and affordable.
Appendix A: Kernel smoothing
We adopt the kernel density function of CI as used by
Silverman (1986) and the probability density function can be
described as


n
x Xt
1 

,
(A.1)
K
f (x) =
nh t=1
h
where Xt represents the historical value of CI in year t, n is the
amount of available CI data, K() is the kernel function, and
h is bandwidth (Silverman, 1986). Kernel function and bandwidth must be determined. There are various types of kernel
function such as Epanechikov kernel, Gaussian kernel, triangle kernel, cosine
kernel, etc. The Gaussian kernel, namely,

exp(u2 /2)/ 2 , is widely used in research but kernel selection is not a major concern.9 In order to estimate the probability
of a certain point, the probabilities of nearby points are taken
into consideration, and the weight assigned to each adjacent
point is determined by kernel function. Bandwidth is used as
an adjuster when smoothing samples. It can be easily deduced
that if (x Xt )/ h remains constant, (x Xt ) will have a wider
range when h increases, and this will make the curve smoother.
That is because in this case, not only more points will be involved in smoothing but also more points that are close to the
estimated point will cluster in high-weight area. So, small bandwidth will reflect more details about the sample, but the curve
may be rough with many bulges caused by random effects,
while oversized bandwidth may lead to oversmoothing, and
some substantial traits may thus be concealed because of the
oversmoothed curve. Therefore, it is pivotal to choose an appropriate bandwidth, which offers a balance between smoothness
and adherence.
The ideal value of h is determined by minimizing the approximate mean integrated standard error (Silverman, 1986)
hopt =

2
k2 5


2

K(t) dt

15 



f (x) dx

15

15

(A.2)

where k2 = t 2 K(t)dt. Several methods are available for estimating optimal h such as Silvermans rule-of-thumb, maximum smoothness, cross validation, etc. The point is that
9

The determination of optimal bandwidth is correlated with kernel function;

by changing bandwidth, different kernels derive similar outcomes.

327

whichever kernel function we choose, the only undetermined

part is f  (x)2 dx. In rule-of-thumb, it is assigned by
5  (x)dx, where (x) denotes standard normal density;
therefore, Equation (A.2) can be simplified to the following
form if the Gaussian kernel is selected
hopt = 1.06 n 5 .
1

(A.3)

As the data deviate from normality (e.g., bimodal distributions, fatter tails, and asymmetry), Silverman (1986) found that
setting = min{standard deviation, (upper quartile lower
quartile)/1.34} and reducing the scaling factor from 1.06 to
0.9 lead to better result in general empirical analysis.10 After
modification by adopting these two principles, the value of hopt
is set as 1.2269.
Appendix B:The mean-semivariance model
The substance of semivariance is that only deviations of
observations below average are considered, where the denominator n is the sample volume including all the observations:

Ui =

Ri E (R)
0

if Ri < E (R)
if Ri E (R) ,

1 2
U ,
n i=1 i

(B.1)

2
=
semi

(B.2)

2
where E(R) and semi
denote expected revenue and semivariance of revenue, respectively.
Therefore, we use the mean-semivariance model to estimate
the efficiency of index insurance in hedging yield risk:

1 2
,
V = E (R) ksemi
2

(B.3)

where k is the coefficient of relative risk aversion (Eeckhoudt

and Gollier, 1995), k = 0.1, 0.2, 0.3, . . ., and a higher value of
k implies that investors are more risk averse. A higher V value
corresponds to lower risk exposure.
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