An analysis of pricing and basis risk for industry loss warranties

In recent years, industry loss warranties (ILWs) have become increasingly popular in the reinsurance market. The defining feature of ILW contracts is their dependence on an in- dustry loss index. The use of an index reduces moral hazard and generally results in lower prices compared to traditional, purely indemnity-based reinsurance contracts. However, use of the index also introduces basis risk since the industry loss and the rein- sured company’s loss are usually not fully correlated. The aim of this paper is to simul- taneously examine basis risk and pricing of an indemnity-based industry loss warranty contract, which is done by comparing actuarial and financial pricing approaches for dif- ferent measures of basis risk. Our numerical results show that modification of the con- tract parameters to reduce basis risk can either raise or lower prices, depending on the specific parameter choice. For instance, basis risk can be reduced by decreasing the in- dustry loss trigger, which implies higher prices, or by increasing the reinsured company attachment, thus inducing lower prices.