What it means
Traditional reinsurance protects an insurer against its own losses. Insurance derivatives work differently, because many of them are tied to an index, such as total industry losses reported by a data provider, or to a physical measure such as rainfall or wind speed.
A catastrophe option is a typical example. The buyer pays a premium and receives a payment if the index rises above an agreed attachment point, up to a maximum payout set at an exhaustion point.
Industry loss warranties and catastrophe swaps are related structures. For an insurer, the appeal is that the capacity comes from the capital markets, and may cost less or be easier to obtain after a major event.
For investors, the appeal is diversification, because natural catastrophe losses have little connection with the economic cycle. A fund can therefore earn a return that is largely independent of stock markets.
The major drawback for the buyer is basis risk, which is the gap between the payout from the contract and the insurer's actual loss. If a hurricane damages the insurer's portfolio far more than the industry index suggests, the derivative may pay too little.
The reverse can also happen, giving the buyer a payment that exceeds its loss. Weather derivatives are a related category used by businesses outside insurance, such as energy companies, farmers and ski resorts.
They hedge revenue against abnormal temperature, rainfall or snowfall, and they pay on the measured weather index, not on proof of damage. Catastrophe bonds, which are often discussed alongside these tools, are bonds rather than derivatives, but they transfer risk to investors in a similar way.
Accounting and regulation add further complexity. A contract that pays on a loss the buyer has actually suffered may be treated as insurance, while one that pays on an index is usually treated as a derivative and measured at fair value.
Companies should take advice on the classification, because it changes how gains, losses and capital requirements are reported.
In practice
Real-world examples.
Example
A property insurer with heavy exposure to coastal homes buys an index-based hurricane option. After a major storm pushes the industry loss index above the attachment point, the contract pays out and helps the insurer meet claims.
Example
A hedge fund that specialises in insurance-linked investments sells catastrophe options to insurers. It earns the premiums in quiet years, and accepts that it will have to pay in a bad season.
Example
A hydroelectric power company buys a rainfall derivative that pays if rainfall in its catchment area falls below a set level. The payment offsets lost revenue from low water levels in a dry year.
Formula
Calculation
Payout = Value per point x Minimum of [Maximum of (Index - Attachment point, 0), (Exhaustion point - Attachment point)]
A reinsurer buys a catastrophe call spread on an industry loss index with an attachment point of 100 and an exhaustion point of 150, paying $20,000 per index point. After a storm season, the index settles at 130. The payout is 20,000 x (130 - 100) = 20,000 x 30 = $600,000. The maximum possible payout is 20,000 x (150 - 100) = 20,000 x 50 = $1,000,000, which would be paid if the index finished at 150 or higher.Case study
Seen in the real world.
Marlowe Mutual is an illustrative, fictional insurer that wrote a lot of homeowners cover in one coastal region. Its reinsurance programme was renewing at a much higher price, so the chief risk officer explored an index-based catastrophe option as a supplement.
The option attached at an industry loss of $20 billion and exhausted at $30 billion, with a limit of $50,000,000 for a premium of $4,000,000. The contract was cheaper than extra reinsurance because it paid on the industry index and not on Marlowe's own claims.
When a storm caused $26 billion of industry losses, the option paid $30,000,000, but Marlowe's own claims were only $24,000,000. The fictional company received more than it lost this time, but the illustrative lesson is that basis risk can run either way and must be monitored.
Watch out
Common mistakes.
- Assuming an insurance derivative pays based on the buyer's own loss, when most pay on an index or a physical measure.
- Ignoring basis risk, which can leave the buyer with a payout that is much smaller than the loss it was meant to cover.
- Treating an insurance derivative as the same as insurance, when it may be classified, taxed and regulated differently.
Questions
People also ask.
How is an insurance derivative different from reinsurance?
Reinsurance pays based on the insurer's actual losses, while a derivative pays based on an agreed index or measurement, which makes it faster and simpler but less precise.
Who invests in insurance derivatives?
Hedge funds, pension funds and specialist insurance-linked securities funds invest in them, because the returns tend to be uncorrelated with other markets.
Are catastrophe bonds insurance derivatives?
They are closely related, but a catastrophe bond is a debt security rather than a derivative, and investors may lose some or all of their principal if a trigger event occurs.
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