Given the problems with some traditional crop insurance programs in developed countries, finding new solutions to help mitigate several aspects of the problems outlined above has become critical. Index insurance products, designed to overcome many of the problems plaguing multiple-peril farm-level crop insurance products, offer some potential in this regard (Skees et al. 1999). ttese contingent claims contracts base payments on an independent measure, such as rainfall or temperature that is highly correlated with farm-level yield or revenue outcomes. Unlike traditional crop insurance that attempts to measure individual farm yields or revenues, index insurance makes use of variables exogenous to the individual policyholder but have a strong correlation to farm-level losses. For most insurance products, a precondition for insurability is that the loss for each exposure unit be uncorrelated (Rejda 2001). For index insurance, a precondition is that risk be spatially correlated. When yield losses are spatially correlated, index insurance contracts can be an effective alternative to traditional farm-level crop insurance. Index products also facilitate transfer of risk into financial markets where investors acquire index contracts as another investment in a diversified portfolio. In fact, index contracts may offer significant diversification benefits, since the returns generally should be uncorrelated with returns from traditional debt and equity markets.
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