Spatial Dependence & Aggregation in Weather Risk Hedging : A Lévy Subordinated Hierarchical Archimedean Copulas (LSHAC) Approach

Adverse weather related risk is a main source of crop production loss and a big concern for agricultural insurers and reinsurers. In response, weather risk hedging may be valuable, however, due to basis risk it has been largely unsuccessful to date. This research proposes the Levy subordinated hierarchical Archimedean copula (LSHAC) model in modelling the spatial dependence of weather risk to reduce basis risk. The analysis shows that the LSHAC model can improve the hedging performance through more accurate modelling of the dependence structure of weather risks and is more effcient in hedging extreme downside weather risk, compared to the benchmark copula models. Further, the results reveal that more effective hedging may be achieved as the spatial aggregation level increases. This research demonstrates that hedging weather risk is an important risk management method, and the approach outlined in this paper may be useful to insurers and reinsurers in the case of agriculture, as well as for other related risks in the property and casualty sector