Basis Risk with PCS Catastrophe Insurance Derivative Contracts

This study provides evidence of the potential hedging effectiveness of insurance derivatives based on regional estimates of catastrophe losses. We estimate the percentage of insurers ’ by line and state underwriting risk that could have been eliminated over the 1974 through 1994 period if they had hedged using state-specific catastrophe derivatives based on Property Claims Service (PCS) reported losses. The results indicate that state-specific PCS catastrophe derivatives would have provided effective hedges for many insurers, especially those selling homeowners insurance. These findings suggest that basis risk is not likely to be a significant problem with state-specific catastrophe derivative contracts. We also compare the hedging effectiveness of state-specific catastrophe contracts to regional catastrophe contracts and to state-specific contracts based on by-line loss ratios.