Pricing Temperature-Index Insurance under Long Memory and Stochastic Time Change

Abstract

This paper develops a unit-consistent actuarial framework for pricing capped cumulative temperature-index insurance under long-range dependence and stochastic variability. Daily temperature anomalies are modeled as increments of fractional Brownian motion evaluated at an operational time generated by the integral of a stationary normalized Cox--Ingersoll--Ross process. We show that the stochastic time change preserves stationarity and the long-memory covariance decay of the increments while introducing additional variability through the random operational clock. The cumulative temperature index admits a conditionally Gaussian representation, which leads to an exact conditional exponential kernel for capped stop-loss contracts and ensures existence of the entropic premium for every positive risk-aversion parameter. Consequently, valuation reduces to an outer Monte Carlo expectation over the accumulated CIR time, avoiding fractional Brownian path simulation and covariance-matrix construction. We further establish monotonicity properties of the premium with respect to risk aversion and conditional volatility. An empirical illustration based on Chicago temperature data shows that both long memory and stochastic time change can materially affect insurance premiums relative to conventional Brownian and fractional Brownian benchmarks, with the Hurst parameter playing an important role in valuation uncertainty. The proposed framework therefore provides a tractable approach for incorporating persistent dependence, stochastic variability, and bounded insurance losses into climate-index pricing.