The influence of non-linear dependencies on the basis risk of industry loss warranties

Abstract

Index-linked catastrophic loss instruments represent an alternative to traditional reinsurance to hedge against catastrophic losses. The use of these instruments comes with benefits, such as a reduction of moral hazard and higher transparency. However, at the same time, it introduces basis risk as a crucial key risk factor, since the index and the company’s losses are usually not fully dependent. The aim of this paper is to examine the impact of basis risk on an insurer’s solvency situation when an industry loss warranty contract is used for hedging. Since previous literature has consistently stressed the importance of a high degree of dependence between the company’s losses and the industry index, we extend previous studies by allowing for non-linear dependencies between relevant processes (high-risk and low-risk assets, insurance company’s loss and industry index). The analysis shows that both the type and degree of dependence play a considerable role with regard to basis risk and solvency capital requirements and that other factors, such as relevant contract parameters of index-linked catastrophic loss instruments, should not be neglected to obtain a comprehensive and holistic view of their effect upon risk reduction.