CAS Exam 9 Spring 2016, Question 19
Study guide: Exam 9
ABC Reinsurance Company is aiming to mitigate its catastrophe risk through a purchase of an Industry Loss Warranty (ILW).
Assume that:
- ABC provides $10 million excess of $5 million reinsurance to Company XYZ on XYZ's catastrophe exposures.
- ABC pays a premium rate on line (ROL) of 10% to purchase $10 million coverage from a binary triggered ILW with a $1 million retention trigger and a $25 billion warranty trigger.
- 1,000 simulations of annual catastrophe loss events with equal probabilities were conducted.
- Only 10 out of 1,000 simulated scenarios generated non-zero modeled losses to either XYZ or to the Industry.
- ABC's management sets its risk capital to equal to the 99.5% Conditional Tail Expectation (CTE) minus the expected loss of the simulated loss distribution.
- ABC's internal guidelines are such that for the ILW to serve as an effective risk mitigation tool, it has to provide a risk capital reduction in excess of the premium paid.
Ignore any acquisition expenses.
| Simulation | Industry Loss (Million) | Ground Up Loss for XYZ (Million) |
|---|---|---|
| 1 | 50,000 | 5,500 |
| 2 | 40,000 | 25,000 |
| 3 | 35,000 | 7,000 |
| 4 | 30,000 | 10,000 |
| 5 | 20,000 | 5,500 |
| 6 | 10,000 | 10,000 |
| 7 | 10,000 | 6,500 |
| 8 | 5,000 | 10,000 |
| 9 | 5,000 | 7,000 |
| 10 | 5,000 | 2,000 |
Part a (3.25 points)
Using ABC's internal guidelines, evaluate whether the above ILW is an effective risk mitigation tool for ABC. Show all calculations and assumptions.
Part b (0.5 points)
Discuss what basis risk means in the context of using the ILW to mitigate catastrophe risk.
Answer this question and see the worked solution