The Basis Risk of Catastrophic-Loss Index Securities

63 Pages Posted: 22 Jun 2000

See all articles by J David Cummins

J David Cummins

Temple University - Risk Management & Insurance & Actuarial Science

David Lalonde

Applied Insurance Research

Richard D. Phillips

Georgia State University - Risk Management & Insurance Department

Date Written: May 2000

Abstract

This paper analyzes the basis risk of catastrophic-loss (CAT) index derivatives, which securitize losses from catastrophic events such as hurricanes and earthquakes. We analyze the hedging effectiveness of these instruments for 255 insurers writing 93 percent of the insured residential property values in Florida, the state most severely affected by exposure to hurricanes. County-level losses are simulated for each insurer using a sophisticated model developed by Applied Insurance Research. We analyze basis risk by measuring the effectiveness of hedge portfolios, consisting of a short position each insurer's own catastrophic losses and a long position in CAT-index call spreads, in reducing insurer loss volatility, value-at-risk, and expected losses above specified thresholds. Two types of loss indices are used ? a statewide index based on insurance industry losses in Florida and four intra-state indices based on losses in four quadrants of the state. The principal finding is that firms in the three largest Florida market-share quartiles can hedge almost as effectively using the intra-state index contracts as they can using contracts that settle on their own losses. Hedging with the statewide contracts is effective only for insurers with the largest market shares and for smaller insurers that are highly diversified throughout the state. The results also support the agency-theoretic hypotheses that mutual insurers are more diversified than stocks and that unaffiliated single firms are more diversified than insurers that are members of groups.

JEL Classification: G22, C15, G32, G13

Suggested Citation

Cummins, J. David and Lalonde, David and Phillips, Richard D., The Basis Risk of Catastrophic-Loss Index Securities (May 2000). Available at SSRN: https://ssrn.com/abstract=230044 or http://dx.doi.org/10.2139/ssrn.230044

J. David Cummins (Contact Author)

Temple University - Risk Management & Insurance & Actuarial Science ( email )

Fox School of Business and Management
1801 Liacouras Walk.
Philadelphia, PA 19122
United States
215-204-8468 (Phone)
215-204-4712 (Fax)

David Lalonde

Applied Insurance Research ( email )

101 Huntington Avenue
Boston, MA 02199
United States
617-267-6645 (Phone)
617-267-8284 (Fax)

Richard D. Phillips

Georgia State University - Risk Management & Insurance Department ( email )

P.O. Box 4036
Atlanta, GA 30303
United States
404-413-7009 (Phone)

HOME PAGE: http://robinson.gsu.edu/profile/richard-d-phillips/

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