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Article
Publication date: 1 March 2000

LIXIN ZENG

Industry loss index‐based risk transfer and management instruments such as the industry loss warranty (ILW) and other catastrophe insurance derivative products have…

Abstract

Industry loss index‐based risk transfer and management instruments such as the industry loss warranty (ILW) and other catastrophe insurance derivative products have proliferated in recent years. This article introduces an alternative measure of the ILW basis risk, specifically the conditional probability that the ILW policy does not pay out, given an actual loss sustained by the policyholder that exceeds some critical level. The author also discusses the effectiveness of upwardly oriented basis risk in reducing loss volatility. After introducing guidelines for choosing between an ILW and traditional reinsurance, the article concludes that a properly structured ILW can be an effective and innovative instrument for a large insurer or reinsurer to manage the severity and volatility of catastrophe losses, but not necessarily, for a medium‐sized or small (re)insurer. Although this article focuses on ILWs, the general methodology and conclusions presented are applicable to other index‐based risk transfer products.

Details

The Journal of Risk Finance, vol. 1 no. 4
Type: Research Article
ISSN: 1526-5943

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Article
Publication date: 16 January 2017

Valeria D’Amato, Mariarosaria Coppola, Susanna Levantesi, Massimiliano Menzietti and Maria Russolillo

The improvements of longevity are intensifying the need for capital markets to be used to manage and transfer the risk through longevity-linked securities. Nevertheless…

Abstract

Purpose

The improvements of longevity are intensifying the need for capital markets to be used to manage and transfer the risk through longevity-linked securities. Nevertheless, the difference between the reference population of the hedging instrument and the population of members of a pension plan, or the beneficiaries of an annuity portfolio, determines a significant heterogeneity causing the so-called basis risk. In particular, it is shown that if insurers use financial instruments based on national indices to hedge longevity risk, this hedge can become imperfect. For this reason, it is fundamental to arrange a model allowing to quantify the basis risk for minimising it through a correct calibration of the hedging instrument.

Design/methodology/approach

The paper provides a framework for measuring the basis risk impact on the. To this aim, we propose a model that measures the population basis risk involved in a longevity hedge, in the functional data model setting. hedging strategies.

Findings

The innovative contribution of the paper occurs in two key points: the modelling of mortality and the hedging strategy. Regarding the first point, the paper proposes a functional demographic model framework (FDMF) for capturing the basis risk. The FDMF model generally designed for single population combines functional data analysis, nonparametric smoothing and robust statistics. It allows to capture the variability of the mortality trend, by separating out the effects of several orthogonal components. The novelty is to set the FDMF for modelling the mortality of the two populations, the hedging and the exposed one. Regarding the second point, the basic idea is to calibrate the hedging strategy determining a suitable mixture of q-forwards linked to mortality rates to maximise the degree of longevity risk reduction. This calibration is based on the key q-duration intended as a measure allowing to estimate the price sensitivity of the annuity portfolio to the changes in the underlying mortality curve.

Originality/value

The novelty lies in linking the shift in the mortality curve to the standard deviation of the historical mortality rates of the exposed population. This choice has been determined by the observation that the shock in a mortality rate is age dependent. The main advantage of the presented framework is its strong versatility, being the functional demographic setting a generalisation of the Lee-Carter model commonly used in mortality forecasting, it allows to adapt to different demographic scenarios. In the next developments, we set out to compare other common factor models to assess the most effective longevity hedge. Moreover, the parsimony for considering together two trajectories of the populations under consideration and the convergence of long-term forecast are important aspects of our approach.

Details

The Journal of Risk Finance, vol. 18 no. 1
Type: Research Article
ISSN: 1526-5943

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Article
Publication date: 1 February 2000

DAVID C. CROSON and HOWARD C. KUNREUTHER

This article examines how reinsurance coupled with new financial instruments can expand coverage to areas exposed to catastrophe losses from natural disasters, and…

Abstract

This article examines how reinsurance coupled with new financial instruments can expand coverage to areas exposed to catastrophe losses from natural disasters, and demonstrates how reinsurance and the catastrophe‐linked financial instruments can be combined to lower the price of protection from its current level. A simple example illustrates the relative advantages and disadvantages of pure catastrophic bonds and pure indemnity reinsurance in supporting a structure of payments contingent on certain extreme events occurring. The authors suggest ways to combine these two instruments using customized catastrophe indices to expand coverage and reduce the cost of protection. This article states six principles for designing catastrophic risk transfer systems and discusses practical issues for implementation, and then concludes with suggestions for future research.

Details

The Journal of Risk Finance, vol. 1 no. 3
Type: Research Article
ISSN: 1526-5943

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Article
Publication date: 1 January 2013

Michael T. Norton, Calum Turvey and Daniel Osgood

The purpose of this paper to develop an empirical methodology for managing spatial basis risk in weather index insurance by studying the fundamental causes for differences…

Abstract

Purpose

The purpose of this paper to develop an empirical methodology for managing spatial basis risk in weather index insurance by studying the fundamental causes for differences in weather risk between distributed locations.

Design/methodology/approach

The paper systematically compares insurance payouts at nearby locations based on differences in geographical characteristics. The geographic characteristics include distance between stations and differences in altitude, latitude, and longitude.

Findings

Geographic differences are poor predictors of payouts. The strongest predictor of payout at a given location is payout at nearby location. However, altitude has a persistent effect on heat risk and distance between stations increases payout discrepancies for precipitation risk.

Practical implications

Given that payouts in a given area are highly correlated, it may be possible to insure multiple weather stations in a single contract as a “risk portfolio” for any one location.

Originality/value

Spatial basis risk is a fundamental problem of index insurance and yet is still largely unexplored in the literature.

Details

The Journal of Risk Finance, vol. 14 no. 1
Type: Research Article
ISSN: 1526-5943

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Article
Publication date: 1 January 2012

Nadine Gatzert and Hato Schmeiser

The purpose of this paper is to provide a detailed analysis of industry loss warranties (ILWs), an alternative risk transfer instrument which has become increasingly…

Abstract

Purpose

The purpose of this paper is to provide a detailed analysis of industry loss warranties (ILWs), an alternative risk transfer instrument which has become increasingly popular throughout the last few years.

Design/methodology/approach

The authors first point out key characteristics of ILWs important to investor and cedent, including transaction costs, moral hazard, basis risk, counterparty risk, industry loss index, and regulation. Next, the authors present and discuss the adequacy of actuarial and financial approaches for pricing ILWs, as well as the aspects of basis risk. Finally, drivers of demand and associated models frameworks from the purchaser's viewpoint are studied.

Findings

Financial pricing approaches for ILWs are highly sensitive to input parameters, which is important given the high volatility of the underlying loss index. In addition, the underlying assumption of replicability of the claims is not without problems. Due to their simple and standardized structure and the dependence on a transparent industry loss index, ILWs are low‐barrier products, which can also be offered by hedge funds. In principle, traditional reinsurance contracts are still preferred as a measure of risk transfer, especially since these are widely accepted for solvency capital reduction. However, the main important impact factor for the demand of ILWs from the perspective of market participants, i.e. large diversified reinsurers and hedge funds, is the lower price due to rather low transaction costs and less documentation effort. Hence, ILWs are attractive despite the introduction of basis risk and the still somewhat opaque regulatory environment.

Research limitations/implications

An important issue for future research is how reinsureds deal with the basis risk inherent in ILWs. Another central point is the development of a European industry loss index and the creation of an exchange platform to enable an even higher degree of standardization and a faster processing of transactions.

Originality/value

ILWs feature an industry loss index to be triggered, and, in some cases, a double‐trigger design that includes a company indemnity trigger. ILW contracts belong to the class of alternative risk transfer instruments that have become increasingly popular, especially in the retrocession reinsurance market. There has been no comprehensive analysis of these instruments in academic literature to date. Consequently, the authors believe that this paper provides a high degree of originality.

Details

The Journal of Risk Finance, vol. 13 no. 1
Type: Research Article
ISSN: 1526-5943

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Article
Publication date: 2 August 2011

Leif Erec Heimfarth and Oliver Musshoff

The purpose of this paper is to analyze the extent to which weather index‐based insurances can contribute to reducing shortfall risks of revenues of a representative…

Abstract

Purpose

The purpose of this paper is to analyze the extent to which weather index‐based insurances can contribute to reducing shortfall risks of revenues of a representative average farm that produces corn or wheat in the North China Plain (NCP). The geographical basis risk is quantified to analyze the spatial dependency of weather patterns between established weather stations in the area and locations where the local weather patterns are unknown.

Design/methodology/approach

Data are based on the Statistical Yearbook of China and the Chinese Meteorological Administration. Methods of insurance valuation are burn analysis and index value simulation. Risk reduction is measured non‐parametrically and parametrically by the change of the standard deviation and the value at risk of revenues. The geographical basis risk is quantified by setting up a decorrelation function.

Findings

Results suggest significant differences in the potential risk reduction between corn and wheat when using insurance based on a precipitation index. The spatial analysis suggests a potential to expand the insurance around a reference weather station up to community level.

Research limitations/implications

Findings are limited by a weak database in China and, in particular, by the unavailability of individual farm data. Moreover, the low density of weather stations currently limits the examination of the approach in a broader context.

Practical implications

The risk reduction potential of the proposed insurance is encouraging. From a policy point of view, the approach used here can support the adjustment of insurers towards different crops.

Originality/value

This paper is believed to be the first that investigates a weather index‐based insurance designed for an average farm in the NCP and the quantification of geographical basis risk.

Details

Agricultural Finance Review, vol. 71 no. 2
Type: Research Article
ISSN: 0002-1466

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Article
Publication date: 23 August 2018

Yugu Xiao and Jing Yao

Agricultural weather index insurance (WII) has been introduced in pilot or experimental form in many countries. However, the effective demand for WII is often limited by…

Abstract

Purpose

Agricultural weather index insurance (WII) has been introduced in pilot or experimental form in many countries. However, the effective demand for WII is often limited by the impact of the basis risk. Thus, the purpose of this paper is to propose a new type of double trigger product, named “supplement” type, to reduce basis risk and improve the performance of the standalone WII.

Design/methodology/approach

Two measures of performance are introduced by the certainty equivalent income of expected utility theory. Through the Monte Carlo experiments and empirical study, this paper compares the performance of three types of double trigger products.

Findings

The findings indicate that the supplement type can significantly improve the performance of the single weather index product. First, it covers the downside basis risk and the catastrophic basis risk when the standalone WII fails to do so, especially in case of extreme losses. Second, it is superior when the correlation between the weather index and the yield index is not so strong, and can further enhance the performance of insurance even when the weather index and the yield index are highly correlated, for which the standalone WII could perform well.

Originality/value

The supplement type double trigger product proposed in this paper as an enhancement version finds a more preferable way to improve the standalone WII with relative lower complexity.

Details

China Agricultural Economic Review, vol. 11 no. 2
Type: Research Article
ISSN: 1756-137X

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Article
Publication date: 28 February 2018

Thomas Url, Franz Sinabell and Karin Heinschink

After several reforms of the common agricultural policy, domestic product prices and farm incomes have become more volatile in the EU. Risk-averse farmers are therefore…

Abstract

Purpose

After several reforms of the common agricultural policy, domestic product prices and farm incomes have become more volatile in the EU. Risk-averse farmers are therefore seeking income stabilizing measures. Margin insurance is among the feasible options but is not yet established in the EU. The purpose of this paper is to explore such an insurance under EU conditions for a major crop.

Design/methodology/approach

The paper explores conditions for a viable margin insurance. It presents a modeled-loss trigger for a margin insurance scheme using wheat production in Austria as the case study.

Findings

While margin insurance products are widely used in the USA, such products are not available in the EU. Basis risk seems to be an important reason. An exploration of wheat production in Austria shows that heterogeneity among farms is relevant. The authors demonstrate an approach aiming to lower basis risks.

Research limitations/implications

This paper presents a technically feasible approach to handle the basis risk of a margin insurance under EU conditions. Before such a product can be placed on the market, further research on systemic risk is needed. Market research is necessary to fine-tune the details of the product to meet the actual demand of farmers. Further empirical validation of the modeled losses is needed. Legal implications are not explored in this paper.

Practical implications

The insurance product presented here demonstrates a concept that is established in the USA under EU conditions. It is motivated by several shortcomings of income risk mitigation approaches in the EU.

Social implications

Income risk may be seen as a problem of social policy. The approach shows that it can be addressed by market-oriented instruments.

Originality/value

To the authors’ knowledge, this paper is the first to propose a tool to handle basis risk for margin insurance products in agriculture in the EU. A special feature of the proposed approach is that it is not limited to a single product such as wheat.

Details

Agricultural Finance Review, vol. 78 no. 2
Type: Research Article
ISSN: 0002-1466

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Article
Publication date: 6 November 2009

Charles C. Yang, Patrick L. Brockett and Min‐Ming Wen

The purpose of this paper is to examine empirically the basis risk and hedging efficiency of temperature‐indexed standardized weather derivatives in hedging weather risks

Abstract

Purpose

The purpose of this paper is to examine empirically the basis risk and hedging efficiency of temperature‐indexed standardized weather derivatives in hedging weather risks in the US energy industry.

Design/methodology/approach

Within the risk minimization framework, using power load and temperature data, this research analyzes both linear and nonlinear hedging strategies using the two most popular types of standardized indexes – city indexes and regional indexes.

Findings

The results indicate that the city indexes and regional indexes are not consistently superior to each other and the regional indexes should be a good complement to the current exchange‐listed indexes. The results also document that the basis risk is sufficiently low for the diversified power producers serving the US Northeast or Mid‐Atlantic regions in both the summer and winter seasons and California in the summer season. However, the basis risk is very high for the diversified power producers serving California in hedging the weather risk in the winter season. More discrepancies are observed in the hedging efficiency among the power producers serving the Texas region.

Originality/value

This research provides important implications about the survivability and superiority of current and proposed standardized weather contracts and the design of effective standardized weather derivatives for the extant and potential weather markets.

Details

The Journal of Risk Finance, vol. 10 no. 5
Type: Research Article
ISSN: 1526-5943

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Article
Publication date: 5 May 2015

Michael Carter, Ghada Elabed and Elena Serfilippi

While behavioral economic experiments have uncovered a wealth of insights concerning how people decide in the face of risk and uncertainty, the implications of these…

Abstract

Purpose

While behavioral economic experiments have uncovered a wealth of insights concerning how people decide in the face of risk and uncertainty, the implications of these insights for the demand for agricultural insurance are under-explored. The purpose of this paper is to report on results from two recent field experiments that measure the extent to which farmer behavior departs from the predictions of expected utility theory and derives the implications of these departures for insurance demand.

Design/methodology/approach

Framed behavioral field experiments were played with random samples of West African Cotton farmers who lived in areas that were being incorporated into a cotton insurance pilot program.

Findings

Substantial numbers of farmers depart from expected utility behavior in ways that predict excess sensitivity to uncovered basis risk in insurance contracts; and, the fact that insurance premiums are typically framed as certain and unavoidable, while benefits are unknown and stochastic.

Originality/value

Using novel field experimental methods, the work summarized here indicates that more careful design of index insurance contracts in conformity with the findings of behavioral economics could result in larger contract uptake and, ultimately, larger development impacts.

Details

Agricultural Finance Review, vol. 75 no. 1
Type: Research Article
ISSN: 0002-1466

Keywords

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