The impact of counterparty risk on the basis risk of industry loss warranties and on (collateralized) reinsurance under (non-)linear dependence structures

What is it about?

As a consequence of alternative risk transfer’s increasing relevance, industry loss warranties and collateralized reinsurance are today prevalent alternatives and supplements to traditional reinsurance. While the higher counterparty risk of new, partially unrated protection sellers can be mitigated via the provision of collateral, collateralization also limits the market penetration of risk transfer instruments. Furthermore, index-based industry loss warranties involve basis risk as an additional risk factor to counterparty risk. The aim of this paper is to investigate how counterparty risk affects the basis risk of industry loss warranties as well as reinsurance with and without collateral and the insurer’s solvency and Sharpe ratio, respectively. Toward this end, we extend existing literature by allowing for the (partial) default of both reinsurance and industry loss warranties under different (non-)linear dependence structures. The analysis shows that the impact of counterparty risk on the hedging efficiency of industry loss warranties is particularly pronounced for higher degrees of dependencies and tail dependent losses, i.e. in cases of basis risk levels that appear low if counterparty risk is not considered. Additionally, already partial collateralization limits counterparty and basis risk to more acceptable levels.

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Photo by Jr Korpa on Unsplash

Photo by Jr Korpa on Unsplash