Securitizing Area Insurance: A Risk Management Approach

Abstract

This paper examines the possibility of developing a risk management instrument by designing a financial security whose value is linked to the average revenue of a given area. This type of program is sufficiently general to be considered for any group of businesses that face production uncertainty. In agriculture, it has been proposed as an alternative to multiple peril crop insurance programs, as area yield, revenue or rainfall insurance in order to eliminate ex ante and ex post moral hazard. While most of the literature concentrates on the determination of value of the indemnity and the payment of such an insurance, this paper focuses on the fact that, unlike other forms of insurance, area insurance can be cast in the form of a hedging security and, as a consequence, rather than depending only on the demand for diversification (the beta of the Capital Asset Price Model), it makes possible a risk shifting strategy based on the heterogeneity of risk attitudes of the economic agents operating in a given area.