Basis Risk with PCS Catastrophe Insurance Derivative Contracts

Abstract

INTRODUCTION The increased frequency and severity of insured losses from natural catastrophes in the past decade have generated a variety of industry responses, including Act of God bonds, new catastrophe reinsurers in Bermuda, the introduction of a catastrophe insurance risk exchange, and the development of catastrophe insurance derivatives (see ISO 1996). Catastrophe derivatives trade at the Chicago Board of Trade (CBOT) and have been introduced by the Bermuda commodities exchange (Greenwald 1997). These contracts have payoffs that depend on indices that measure insured losses from catastrophes in specific geographical regions. In principle, insurers can use these contracts to reduce their exposure to underwriting losses due to catastrophes. Hedging using index-based derivatives has the potential to reduce contracting costs, moral hazard, and tax costs relative to other methods of managing underwriting risk, such as reinsurance and equity capital (e.g., Niehaus and Mann 1992; Harrington, Mann, and Niehaus 1995). A potential shortcoming is that index-based derivative contracts can have considerable basis risk, i.e., the losses on a particular insurer's book of business may not be highly correlated with the indices underlying the contracts so that little underwriting risk can be eliminated. Since the amount of basis risk is fundamental to the success of derivative contracts (Black 1986), the main purpose of this paper is to examine the basis risk of catastrophe insurance derivative contracts. The first insurance derivative contracts, introduced by the CBOT in December 1992, were futures contracts based on the underwriting results of twenty-two insurers for the entire country and for three regions of the United States (east, mid-west, and west). Trading volume for these contracts was anemic during their two years of existence, which has been attributed to several factors, including: (1) insurers/reinsurers' preference for option spreads (a long call position combined with a short call position with a higher exercise price) as opposed to futures contracts because option spreads have payoffs similar to catastrophe reinsurance contracts (Cummins and Geman 1994; 1995); (2) the lack of historical data on the underlying indices (D'Arcy and France 1992); and (3) the basis risk associated with broad geographical indices. The CBOT discontinued the futures contracts and now only trades option contracts based on Property Claims Service's (PCS) estimates of catastrophe losses in specific geographical regions. The new contracts were designed to address many of the concerns of the original contracts. First, a wide variety of call spreads can be created and prices are quoted on pre-packaged call spreads. Second, data on the underlying indices are available beginning in 1949. Third, PCS option contracts are available on nine indices: a national index, five regional indices (Eastern, Northeastern, Southeastern, Midwestern and Western), and three individual state indices (California, Florida and Texas). While trading volume in these second-generation contracts is greater than the first generation contracts, overall volume has still been relatively low. It is worth noting, however, that some very successful derivative contracts (e.g., the T-bond futures contract) had low volume when first introduced. Although the more narrowly defined geographical areas should help reduce basis risk, industry analysts continue to cite basis risk as one of the main shortcomings of the PCS catastrophe options (Major 1997; Himick 1997). Critics contend that regional and even state-specific contracts cover too broad a geographical area and that contracts based on counties or zip codes might be better. A larger menu of disaggregated contracts (e.g., contracts for each zip code in Florida versus one Florida contract) can enhance an insurer's ability to combine contracts to form a portfolio of derivative contracts that is highly correlated with the insurer's book of business. …