The following paper discusses industry loss warranties (ILWs). The aim of this essay is to analyze basis risk with the help of Excel simulation study and to perform a risk and pricing sensitivity analysis. Furthermore, on the basis of obtained results the hedging effectiveness of ILW contracts in comparison to traditional reinsurance shall be assessed.
In company with traditional reinsurance and catastrophic bonds (cat bonds) ILWs protect buyers against natural catastrophes. The increased number of natural disasters in last years (Hurricane Katrina and Ivan in 2005, Hurricane Irene in 2011) led to lack of supply capacity in the traditional reinsurance and retrocession market. Insurers required additional capital. Therefore new and innovative catastrophic instruments – such as industry loss warranties or cat bonds – were developed (see Gatzert and Schmeiser, 2009, p.2).
These new index-linked instruments have several advantages in comparison to traditional reinsurance, e.g. reduction of moral hazard or lower underwriting costs, but a potential buyer has also to consider the drawbacks: The most important one is basis risk (see Gatzert and Kellner, 2011a, p. 132).
In the beginning this paper describes the characteristics of ILWs and discusses their pros and cons in comparison to other insurance instruments. In addition, the most common definitions of basis risk are introduced. An introduction of simulation study follows, beginning with a theoretical presentation of the approach used in the study. Subsequently, every single step as well as the formulas and the methods used are described. A following numerical analysis discusses the obtained results from the simulation study and sensitivity analysis. Lastly a conclusion is drawn, where ILWs and their hedging effectiveness on the basis of gained information are compared to the traditional reinsurance.
Table of Contents
- Introduction
- Characteristics of Industry Loss Warranties
- Examples of an Industry Loss Warranty contract
- Basis Risk
- Comparison with other risk-transfer instruments
- Simulation Study
- Approach
- Measuring basis risk
- Premium calculation
- Risk measurement
- Numerical analysis
- Value at risk and tail value at risk
- Varying coefficient of correlation
- Varying industry loss trigger
- Varying retention
- Varying limit of protection
- Approach
- Summary
Objectives and Key Themes
This seminar paper aims to analyze the basis risk inherent in Industry Loss Warranties (ILWs). It investigates the characteristics of ILWs, compares them to other risk-transfer instruments, and employs a simulation study to quantify basis risk under varying parameters.
- Characteristics of Industry Loss Warranties
- Basis Risk in ILWs
- Comparison of ILWs with other risk transfer instruments
- Simulation study methodology and results
- Quantitative analysis of basis risk factors
Chapter Summaries
Introduction: This chapter introduces the topic of basis risk in Industry Loss Warranties (ILWs), highlighting the importance of understanding this risk in the context of insurance and risk management. It sets the stage for the subsequent chapters by outlining the research objectives and methodology. The introduction lays the groundwork for a comprehensive examination of the complexities surrounding ILWs and their associated risks, emphasizing the significance of the research in the field of insurance and risk management.
Characteristics of Industry Loss Warranties: This chapter delves into the nature of Industry Loss Warranties, providing examples of contract structures and a detailed examination of basis risk. It compares ILWs with alternative risk-transfer mechanisms, highlighting their unique features and the implications for risk management. The chapter establishes a foundational understanding of ILWs, their inherent complexities, and how they differ from other risk-transfer methods, thereby setting the stage for the quantitative analysis that follows.
Simulation Study: This chapter presents a comprehensive simulation study designed to quantify basis risk in ILWs. It describes the methodological approach, detailing the parameters used in the simulations and the methods for measuring basis risk, premium calculation, and overall risk measurement. The chapter then presents a thorough numerical analysis, exploring the impact of various factors, such as correlation coefficients, industry loss triggers, retention levels, and limits of protection, on the overall basis risk. The results provide valuable insights into the dynamics of basis risk in ILWs and their implications for risk management strategies.
Keywords
Industry Loss Warranty, Basis Risk, Risk Transfer, Insurance, Simulation, Value at Risk (VaR), Tail Value at Risk (TVaR), Correlation, Retention, Limit of Protection, Risk Management.
Frequently Asked Questions: Analysis of Basis Risk in Industry Loss Warranties
What is the main topic of this document?
This document provides a comprehensive overview and analysis of basis risk inherent in Industry Loss Warranties (ILWs). It explores the characteristics of ILWs, compares them to other risk-transfer instruments, and uses a simulation study to quantify basis risk under various parameters.
What are Industry Loss Warranties (ILWs)?
Industry Loss Warranties are insurance contracts that transfer the risk of industry-wide losses to an insurer. The document delves into the specifics of ILW contracts, illustrating their structure and exploring the concept of basis risk within these contracts. A comparison with other risk transfer mechanisms is also provided.
What is basis risk in the context of ILWs?
Basis risk, in this context, refers to the discrepancy between the insured's actual losses and the industry-wide losses used to trigger the ILW payout. The document thoroughly investigates this key risk factor and its implications.
What methodologies are used to analyze basis risk in ILWs?
The document employs a simulation study to quantitatively assess basis risk. The methodology includes measuring basis risk, calculating premiums, and measuring overall risk using metrics such as Value at Risk (VaR) and Tail Value at Risk (TVaR). The simulation varies key parameters like correlation coefficients, industry loss triggers, retention levels, and limits of protection to understand their impact.
What are the key parameters varied in the simulation study?
The simulation study systematically varies several crucial parameters: the coefficient of correlation between the insured's losses and industry losses; the industry loss trigger; the retention level (the amount of loss the insured retains before the ILW kicks in); and the limit of protection (the maximum amount the ILW will pay out).
What are the key findings of the simulation study?
The numerical analysis section of the simulation study presents the quantitative results of how each of the varied parameters impacts the basis risk. While the specific results aren't detailed in the preview, the study provides valuable insights into the dynamics of basis risk and its implications for risk management strategies.
What other risk transfer instruments are compared to ILWs?
The document compares ILWs to other risk transfer instruments, highlighting their unique characteristics and implications for risk management. The specific instruments compared are not listed in this preview.
What are the key objectives of this document?
The primary objective is to analyze the basis risk inherent in ILWs. Other objectives include investigating the characteristics of ILWs, comparing them to other risk-transfer instruments, and employing a simulation study to quantify basis risk under varying parameters.
What are the key themes explored in this document?
Key themes include the characteristics of Industry Loss Warranties, basis risk in ILWs, comparison of ILWs with other risk transfer instruments, simulation study methodology and results, and a quantitative analysis of basis risk factors.
What keywords are associated with this document?
Key words include Industry Loss Warranty, Basis Risk, Risk Transfer, Insurance, Simulation, Value at Risk (VaR), Tail Value at Risk (TVaR), Correlation, Retention, Limit of Protection, and Risk Management.
- Quote paper
- Elena Rudnikevic (Author), 2012, On the Basis Risk of Industry Loss Warranties, Munich, GRIN Verlag, https://www.grin.com/document/190947
