The impact of counterparty risk on the basis risk of industry loss warranties and on (collateralized) reinsurance under (non-)linear dependence structures
ISSN: 1526-5943
Article publication date: 22 February 2022
Issue publication date: 21 April 2022
Abstract
Purpose
The purpose of this article is to investigate the impact of counterparty risk on the basis risk of industry loss warranties as well as on reinsurance with and without collateral under different dependence structures. The authors additionally compare the solvency and Sharpe ratio for different premium loadings and contract parameters.
Design/methodology/approach
The authors propose a model framework extension to account for the counterparty risk of risk transfer arrangements. Copulas are used to also take into account non-linear dependencies between risk factors, and Monte Carlo simulation is employed to derive numerical results and to conduct sensitivity analyses.
Findings
The authors show that the impact of counterparty risk is particularly pronounced for higher degrees of dependencies and tail dependent losses, i.e. in cases of basis risk levels that appear low if counterparty risk is not considered. With respect to counterparty risk management, the authors find that already partial collateralization limits counterparty and basis risk to more acceptable levels.
Practical implications
The study results are particularly relevant to practitioners, as insurers may not only underestimate the “true” basis risk of index-linked instruments, but also the effect of counterparty risk of reinsurance contracts along with the consequences for solvency and profitability.
Originality/value
The authors extend existing literature by allowing for the (partial) default of industry loss warranties and reinsurance under different dependence structures. Furthermore, the authors include profitability in addition to risk considerations. The interaction effects between counterparty risk and the basis risk of index-based alternative risk transfer instruments are largely unstudied, despite their considerable relevance in practice.
Keywords
Acknowledgements
The authors would like to thank an anonymous referee and the participants of the 25th Annual Conference of the Asia-Pacific Risk and Insurance Association (APRIA) and the 2021 Annual Meeting of the American Risk and Insurance Association (ARIA) for helpful comments and suggestions on an earlier version of this paper.
Heike Bockius gratefully acknowledges financial support by the German National Academic Foundation. The funding source had no involvement in the conduct of the research and/or the preparation of this article.
Citation
Bockius, H. and Gatzert, N. (2022), "The impact of counterparty risk on the basis risk of industry loss warranties and on (collateralized) reinsurance under (non-)linear dependence structures", Journal of Risk Finance, Vol. 23 No. 3, pp. 245-263. https://doi.org/10.1108/JRF-06-2021-0103
Publisher
:Emerald Publishing Limited
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