Is diversification effective in reducing the systemic risk implied by a market for weather index-based insurance in Spain?

Abstract

This study assesses how effective spatial diversification is in reducing the systemic risk implied by a market for weather index-based insurance in Spain and compares rainfall- and temperature-based policies in terms of systemic risk. Based on historical weather data, daily models which rely on the multivariate normal distribution are applied to derive greater samples. The results show that the Buffer Load, as measured by the Expected Shortfall, decreases up to 67% as the level of aggregation increases. This suggests that the trading area should not be focused on a specific county, but on Spain as a whole. Considering the highest aggregation degree, it is also shown that the diversification effect is significant, of up to 0.35. Finally, it is noted that rainfall insurance is a less-risky alternative as compared to temperature-geared contracts, as it implies lower losses and prices and stronger risk pooling effectiveness. Therefore, we recommend the inclusion of this type of policies in the insurance companies’ portfolio. Finally, although this study focuses on a specific country, the proposed methodology can be easily extrapolated to other geographical areas.