Precipitation or water capacity indices? An analysis of the benefits of alternative underlyings for index insurance

Eastern Germany is often hit by drought causing income risk for crop farmers. Index-based risk management instruments could help crop farmers to reduce their farm income risk. Such instruments have some important advantages over damage-based insurance, like e.g. less moral hazard and adverse selection. At the same time they typically have a high level of basis risk. Up to now, mainly precipitation-based weather derivatives have been discussed as an appropriate risk management instrument for farmers in Germany. As a potentially more effective alternative, we propose water capacity-based index insurance. In order to show the benefits of a precipitation-based and water capacity-based index insurance, several contract designs are compared. Using a whole farm risk program planning approach, we show that for an average agricultural producer in Eastern Germany water capacity-based index insurance offers greater benefits than precipitation-based index insurance.