Price Index Insurances in the Agriculture Markets

In this article, we introduce price index insurances on agricultural goods. Although these seem similar to derivatives, there are significant differences between price index insurances and derivatives. First, unlike derivatives, there are no entrance barriers for purchasing insurances, making them the risk management tools that are accessible to almost all farmers. Second, since insurances are issued in a certain number for any individual farm, unlike futures, for example, they cannot be used for speculation and are used solely for hedging price risk. Third, unlike forwards, they are heavily regulated and do not default and cause counterparty risk. In addition to all differences (or benefits), such products have just recently been introduced in the agricultural insurance market. In this article, we investigate if there could have been a financially viable market where these products are traded. More precisely, we investigate whether an insurance company can design a portfolio of optimal contracts that gives a higher Sharpe ratio than the financial market index prices (here, FTSE 100 and other three major indexes). To reach the article’s objective, we take three steps, in considering theoretical, practical, and corporation standpoints. In the first step, we show what an optimal contract would look like from the demand side in a theoretical setup and we obtain the optimal contract from the farmers' standpoint. In the second step, by adopting a more practical approach in meeting the Key Performance Indicators requirements set by the market participants (both demand and supply side), we find the optimal policies specifications from the first step, in the market equilibrium. This step also helps to determine some unobservable market parameters like volatility. Finally, by adopting a corporation standpoint we bring our model to the U.K. farm index prices and find an optimal portfolio of the products on products from 10 commodities. We demonstrate that investing in such a business is financially viable, as the optimal insurance portfolio produces a Sharpe ratio that outperforms the FTSE 100 and other major market indexes.