Insurance-linked securities are often used to hedge an insurer’s exposure to catastrophic property losses, but the casualty insurance market is just beginning to recognize the potential of ILS products.Executive Summary Guy Carpenter experts believe that casualty insurance risk can be hedged using ILS products with manageable basis risk and reasonable margins. In this article, Michelle Harnick and Jose Couret explain an index developed specifically to hedge the impact of systemic risk on an individual insurance or reinsurance company’s loss reserves.
Under an industry loss warranty (ILW) for property, the reinsurance recovery is linked to an index incorporating the entire insurance industry’s experience—not just the buyer’s. In theory, the insurer’s actual losses from some catastrophic event and the value of the index corresponding to the same event should be correlated.
One major advantage of an index-based approach is that there is little or no moral hazard. The near absence of moral hazard not only reduces the cost of coverage but also expands the universe of potential sellers beyond that of traditional reinsurers to include capital markets investors. The tradeoff of using an index-based product is the presence of basis risk.