Catastrophe Risk Management – Implications of Default Risk and Basis Risk

A major problem for insuring catastrophic risk is that, as a disaster causes damages to many insureds at the same time, such insurance and in particular reinsurance contracts are often subject to considerable default risk. On the other hand, the securitization of insurance risk, for example via a catastrophe bond, can be designed to completely avoid default risk. In many cases, however, the payout from an insurance-linked security is tied to some stochastic variable, an index, which is correlated, but not identical, with the insured’s actual losses. Therefore, such an instrument will usually not provide a perfect hedge. There will be some mismatch, the so-called basis risk. This paper investigates how the trade off between default respectively credit risk and basis risk affects optimal risk management solutions, when (re)insurance and risk securitization are used simultaneously. In particular, the impact of credit risk and risk securitization on the optimal reinsurance contract is analysed.