On the Basis Risk of Industry Loss Warranties

Abstract

Industry loss index‐based 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 medium‐sized or small (re)insurer. Although this article focuses on ILWs, the general methodology and conclusions presented are applicable to other index‐based risk transfer products.

Citation

ZENG, L. (2000), "On the Basis Risk of Industry Loss Warranties", Journal of Risk Finance, Vol. 1 No. 4, pp. 27-32. https://doi.org/10.1108/eb043452