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The basis risk of catastrophic-loss index securities

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  • Cummins, J. David
  • Lalonde, David
  • Phillips, Richard D.

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 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.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 71 (2004)
Issue (Month): 1 (January)
Pages: 77-111
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Handle: RePEc:eee:jfinec:v:71:y:2004:i:1:p:77-111

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Web page: http://www.elsevier.com/locate/inca/505576

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References

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  1. Neil A. Doherty, 1997. "Financial Innovation in the Management of Catastrophe Risk," Center for Financial Institutions Working Papers 98-12, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. John Major, 1999. "Index Hedge Performance: Insurer Market Penetration and Basis Risk," NBER Chapters, in: The Financing of Catastrophe Risk, pages 391-432 National Bureau of Economic Research, Inc.
  3. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
  4. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1992. "Risk Management: Coordinating Corporate Investment and Financing Policies," NBER Working Papers 4084, National Bureau of Economic Research, Inc.
  5. Mayers, David & Smith, Clifford W, Jr, 1992. "Executive Compensation in the Life Insurance Industry," The Journal of Business, University of Chicago Press, vol. 65(1), pages 51-74, January.
  6. J. David Cummins & Christopher M. Lewis & Richard D. Phillips, 1998. "Pricing Excess-of-loss Reinsurance Contracts Against Catastrophic Loss," Center for Financial Institutions Working Papers 98-09, Wharton School Center for Financial Institutions, University of Pennsylvania.
  7. Neil A. Doherty, 1997. "Financial Innovation in the Management of Catastrophe Risk," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(3), pages 84-95.
  8. Anthony Santomero, 1997. "Commercial Bank Risk Management: An Analysis of the Process," Journal of Financial Services Research, Springer, vol. 12(2), pages 83-115, October.
  9. Dwight M. Jaffee & Thomas Russell, 1996. "Catastrophe Insurance, Capital Markets and Uninsurable Risks," Center for Financial Institutions Working Papers 96-12, Wharton School Center for Financial Institutions, University of Pennsylvania.
  10. Anthony M. Santomero, 1997. "Commercial Bank Risk Management: An Analysis of the Process," Center for Financial Institutions Working Papers 95-11, Wharton School Center for Financial Institutions, University of Pennsylvania.
  11. Ederington, Louis H, 1979. "The Hedging Performance of the New Futures Markets," Journal of Finance, American Finance Association, vol. 34(1), pages 157-70, March.
  12. Dong-Hyun Ahn & Jacob Boudoukh & Matthew Richardson & Robert F. Whitelaw, 1999. "Optimal Risk Management Using Options," Journal of Finance, American Finance Association, vol. 54(1), pages 359-375, 02.
  13. Robert F. Engle & Simone Manganelli, 1999. "CAViaR: Conditional Value at Risk by Quantile Regression," NBER Working Papers 7341, National Bureau of Economic Research, Inc.
  14. Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
  15. Michael S. Canter & Joseph B. Cole & Richard L. Sandor, 1997. "Insurance Derivatives: A New Asset Class for the Capital Markets and a New Hedging Tool for the Insurance Industry," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(3), pages 69-81.
  16. Vivek J. Bantwal & Howard C. Kunreuther, 1999. "A Cat Bond Premium Puzzle?," Center for Financial Institutions Working Papers 99-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
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Citations

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Cited by:
  1. Ricardo Caballero G, 2002. "Coping With Chile’s External Vulnerability: A Financial Problem," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 5(1), pages 11-36, April.
  2. Nell, Martin & Richter, Andreas, 2004. "Catastrophic events as threats to society: Private and public risk management strategies," Working Papers on Risk and Insurance 12, University of Hamburg, Institute for Risk and Insurance.
  3. Epperson, James E., 2008. "Securitizing peanut production risk with catastrophe (CAT) bonds," Faculty Series 44512, University of Georgia, Department of Agricultural and Applied Economics.
  4. Nell, Martin & Richter, Andreas, 2002. "Improving risk allocation through cat bonds," Working Papers on Risk and Insurance 10, University of Hamburg, Institute for Risk and Insurance.
  5. Alexander Harin, 2004. "Arrangement Infringement Possibility Approach: Some Economic Features of Large-Scale Events," Risk and Insurance 0409002, EconWPA.
  6. Fujita, Takahiko & Ishimura, Naoyuki & Tanaka, Daichi, 2008. "An Arbitrage Approach to the Pricing of Catastrophe Options Involving the Cox Process," Hitotsubashi Journal of Economics, Hitotsubashi University, vol. 49(2), pages 67-74, December.

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