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On the Basis Risk of Industry Loss Warranties

On the Basis Risk of Industry Loss Warranties Industry loss indexbased risk transfer and management instruments such as the industry loss warranty ILW and other catastrophe insurance derivative products have proliferated in recent years. This article introduces an alternative measure of the ILW basis risk, specifically the conditional probability that the ILW policy does not pay out, given an actual loss sustained by the policyholder that exceeds some critical level. The author also discusses the effectiveness of upwardly oriented basis risk in reducing loss volatility. After introducing guidelines for choosing between an ILW and traditional reinsurance, the article concludes that a properly structured ILW can be an effective and innovative instrument for a large insurer or reinsurer to manage the severity and volatility of catastrophe losses, but not necessarily, for a mediumsized or small reinsurer. Although this article focuses on ILWs, the general methodology and conclusions presented are applicable to other indexbased risk transfer products. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Risk Finance Emerald Publishing

On the Basis Risk of Industry Loss Warranties

ZENG, LIXIN
The Journal of Risk Finance , Volume 1 (4): 6 – Mar 1, 2000
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Publisher
Emerald Publishing
Copyright
Copyright © Emerald Group Publishing Limited
ISSN
1526-5943
DOI
10.1108/eb043452
Publisher site
See Article on Publisher Site

Abstract

Industry loss indexbased risk transfer and management instruments such as the industry loss warranty ILW and other catastrophe insurance derivative products have proliferated in recent years. This article introduces an alternative measure of the ILW basis risk, specifically the conditional probability that the ILW policy does not pay out, given an actual loss sustained by the policyholder that exceeds some critical level. The author also discusses the effectiveness of upwardly oriented basis risk in reducing loss volatility. After introducing guidelines for choosing between an ILW and traditional reinsurance, the article concludes that a properly structured ILW can be an effective and innovative instrument for a large insurer or reinsurer to manage the severity and volatility of catastrophe losses, but not necessarily, for a mediumsized or small reinsurer. Although this article focuses on ILWs, the general methodology and conclusions presented are applicable to other indexbased risk transfer products.

Journal

The Journal of Risk Finance – Emerald Publishing

Published: Mar 1, 2000

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