Spatial Aggregation and Weather Risk Management
The failures of crop insurance markets in the form of high loss ratios, low participation
rates, and the aversion of private insurance companies to bearing exposures have been
documented extensively. Early explanations attributed these failures primarily to
information asymmetries related to moral hazard and adverse selection (Chambers 1989;
Skees and Reed 1986; Nelson and Loehman 1987; Goodwin and Smith 1995; Gardner
1994; Just and Calvin 1994; Quiggen 1994; Quiggen, Karagiannis and Stanton 1994).1
More recently, a different view has gained support that relates market failures to the
inherent systemic nature of the risks in insuring agricultural production (Miranda and
Glauber 1997; Duncan and Meyers 2000; and Mason, Hayes and Lence 2003).
Systemic risk in agricultural insurance markets stems from spatially correlated
adverse weather events. Research on this explanation concentrates primarily on
identifying the nature and magnitude of systemic risks (Mason, Hayes and Lence 2003;
Miranda and Glauber 1997) and on investigating ways in which the risks can be managed
utilizing private reinsurance and capital markets (Hayes, Lence and Mason 2004; Turvey,
Nayak and Sparling 1999; Miranda and Glauber 1997). To date, no empirical
investigation of reinsurance hedging with weather derivatives (WDs) has been conducted
A key characteristic of agriculture is that it is extremely weather sensitive, and the
use of WDs in agriculture has received increased attention recently. Currently, the WD
market is the fastest growing derivative market in the world (Brockett, Wang and Yang
2005). According to the Chicago Mercantile Exchange (CME) the value of CME
Weather products grew nine fold in the first nine months of 2005, growing from $2.2