A Credibility-Based Yield Forecasting Model for Crop Reinsurance Pricing and Weather Risk Management

Abstract

Purpose
The purpose of this paper is to propose an improved reinsurance pricing framework, which includes a crop yield forecasting model that integrates weather variables and crop production information from different geographically correlated regions using a new credibility estimator, and closed form reinsurance pricing formulas. A yield restatement approach to account for changing crop mix through time is also demonstrated.

Design/methodology/approach
The new crop yield forecasting model is empirically analyzed based on detailed farm-level data from Manitoba, Canada, covering 216 crop varieties from 19,238 farms from 1996 to 2011. As well, corresponding weather data from 30 stations, including daily temperature and precipitation, are considered. Algorithms that combine screening regression, cross-validation and principal component analysis are evaluated for the purpose of achieving efficient dimension reduction and model selection.

Findings
The results show that the new yield forecasting model provides significant improvements over the classical regression model, both in terms of in-sample and out-of-sample forecasting abilities.

Research limitations/implications
The empirical analysis is limited to data from the province of Manitoba, Canada, and other regions may show different results.

Practical implications
This research is useful from a risk management perspective for insurers and reinsurers, and the framework may also be used to develop improved weather risk management strategies to help manage adverse weather events.

Originality/value
This is the first paper to integrate a credibility estimator for crop yield forecasting, and develop a closed form reinsurance pricing formula.

Keywords: yield forecasting, model selection, principal component analysis, cross validation, credibility theory

JEL Classification: C10, G13, G22