Index Hedge Performance: Bootstrap Study of Hurricane Fran

Index-based catastrophe derivatives are an important development in insurance risk securitization because they provide a means of standardizing risk. This is critically important in generating the liquidity investors want and the capacity hedgers need. However, insurers are concerned that their unique loss experience may not correlate highly enough with existing catastrophe indices and that unexpected variation in hedge performance, i.e. basis risk, may be so large as to render these instruments ineffective as risk management tools. This study examines index-based hedge performance using the Guy Carpenter Catastrophe Index (GCCI). Based on 16 companies’ actual exposure and loss data for Hurricane Fran in North Carolina, the performances of ZIP-based and statewide hedges are quantitatively compared by generating a series of hedge statistics using a bootstrap approach. It is found that a ZIP-based hedge is significantly more efficient than a comparable statewide hedge.