Evaluating Alternative Drought Indicators in a Weather Index Insurance Instrument

Weather index insurance is a popular means of mitigating agricultural risks. Drought is a significant cause of lost agricultural production, and so precipitation index-based plans are common. Simple percent of normal indices are often used because they are easy to calculate and communicate to policyholders. However, the ability of such indices to reflect production losses is limited, reducing the ability of insurance to efficiently mitigate risk. This is especially true in rangeland livestock production given the cumulative effects of rainfall and other factors on range production and the complex relationships between range and livestock weight gain, which is the rancher's main product and source of income. More sophisticated drought indices incorporate the complexities of drought into their design and would, in theory, serve as more appropriate payment triggers. This study uses a suite of drought indices to test correlation with production and the behavior of insurance based on those indices. Payout patterns based on each index were simulated within the actuarial framework of a precipitation-based insurance program aimed at livestock producers. Results were compared with the program's precipitation index, showing that drought indices have higher correlations with range production, a tendency to incentivize growing-season protection, more even geographic distributions of risk, reduced policyholder ability to seek higher payments through strategic coverage choices, and increased provider ability to adjust payment patterns to reduce the risk of nonpayment given loss.