Insurance-Linked Securities Report 2008 - Aon

Insurance-Linked Securities 2008
30
The Nemesis: Basis Risk
The risk that an insurer or investor would recover less from a hedging product than
their actual event loss has beleaguered insurance derivatives since their inception.
Although traders can be satisfied with less-than-perfect hedges, many insurance and
reinsurance risk managers desire more precise coverage. While a set of nine regional
index contracts is more appealing than a single national index, the diversity does
not go far enough to reduce basis risk for many insurers.
The effectiveness of more specific derivatives has been studied and substantiated
on a state-specific basis. In a recent analysis, Harrington and Hipp compared
individual insurers’ annual loss ratios to state-specific catastrophe loss ratios using
PCS data. They found that “state-specific catastrophe derivatives could be used
effectively to hedge insurers’ aggregate underwriting results across lines and
states.” In these contracts, coverage is afforded to perils in specific states or groups
of states. However, such disaggregation has not yet been developed in derivative
form due to difficulties in developing interest and liquidity.
While the ILS derivatives market has the potential to increase—indeed, create—
efficiencies among those wishing to trade U.S. hurricane risk, the existing contracts
still do not sufficiently address the persistent problem of basis risk. In the case of
IFEX, for example, geography-specific contracts for sub-zones such as Florida and
the Gulf Coast will narrow the gap between an insurer’s risk and its management
needs. For insurers with diverse businesses, a combination of derivatives (including
the new regional contracts) would have to be statistically evaluated to determine if
it presents a risk management alternative to traditional reinsurance or ILWs.
Use Of Derivative Platforms
Market participants, including insurers, investors, and speculators, will respond
positively to derivatives that provide efficient risk transfer. However, efficiency in the
catastrophe derivatives market requires a certain level of liquidity that does not yet
exist. As a complement (and/or competitor) to ILWs, the derivatives market does not
offer sufficient volumes. Consider that one would need to purchase 500 ELF contracts
at $10,000 each to replace one $5 million ILW. This would represent an unwieldy
transaction in today’s market. Until the derivatives market becomes more liquid and
experienced, participants will continue to make use of existing options like traditional
reinsurance, catastrophe bonds and ILWs. These options are more readily available
and proven versus the existing set of derivatives, particularly in a market where
reinsurance exists at an equivalent or near-equivalent cost to newer instruments.