Hedging Catastrophe Risk Using Index-Based Reinsurance Instruments

Index-based hedging instruments such as industry loss warranties are increasingly recognized as effective hedging tools for insurance and reinsurance portfolios. However, wider adoption of these instruments is inhibited by basis risk, the difference between the index-based payoff and the buyer's actual loss. This study presents a systematic approach for potential buyers to analyze and manage basis risk in order to take full advantage of the benefits offered by these instruments. We examine two measures of basis risk (I) hedging effectiveness and (ii) conditional payoff shortfall. Many existing measures such as hedge volatility and correlation are special cases of the hedging effectiveness measure. Next, we study the tradeoff between basis risk and the cost of hedging. Finally, we present a robust numerical algorithm designed to optimize an index-based hedging program consisting of multiple index-based contracts.