The Better Trigger: Insuring Against Disaster Risk
50 Pages Posted: 3 Mar 2014 Last revised: 19 Nov 2014
Date Written: October 16, 2014
Index triggers have enabled the extension of insurance to disaster risks by providing a simple mechanism to determine insurance payment. Disaster risks are notoriously difficult to insure against due to the covariant nature of risks, moral hazard and adverse selection. Index based risk transfer minimizes these obstacles by not fully insuring the risk. However, such incompleteness generates basis risk, that is the risk that claims do not match losses. This paper analyzes the upside basis risk (receiving a claim without a loss) and downside basis risk (having a loss but no claim) to determine a partial order ranking of indices for any risk averse individual. The partial ranking allows the selection of an index that is optimal for any individual with unknown risk aversion. Results demonstrate that correlation and covariance can provide incorrect comparisons between indices.
Keywords: catastrophes, index based risk transfer, basis risk, partial ranking, insurance
JEL Classification: D14, D81, G22, O16
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