Basis Risk and Cat Risk Management

Abstract: Index-based securities can be used to manage the risk of losses from catastrophic events such as hurricanes and earthquakes. In contrast to traditional (indemnity-based) covers the distinction between index value and the company's own loss experience gives rise to some basis risk in transactions of this type. After a short motivation the distribution of the basis risk will be formulated in terms of the copula connecting the index and the losses. Next we will show how such a formulation in terms of a copula can be used to understand the efficiency of the securitization.