Insurer Capital Structure Decisions and the Viability of Insurance Derivatives

Abstract

Insurance futures contracts and options on these contracts developed by the Chicago Board of Trade provide a means for insurers and reinsurers to hedge underwriting losses due to industry-wide shocks, such as natural catastrophes. In order for insurance derivatives to be viable, they must lower insurers' costs compared to other methods that mitigate the effects of correlated risk, such as holding additional equity capital and purchasing reinsurance. This article identifies the tradeoffs associated with using insurance derivatives versus alternative methods of dealing with correlated risk. Particular attention is focused on whether insurance derivatives can efficiently reduce the need for equity capital. In addition, empirical evidence is provided on the magnitude of correlated risk and the potential effectiveness of futures in hedging this risk.