The derivatives market as a whole can be described as an insurance exchange— buyers and sellers meet to exchange products which offer protection from unexpected events and volatile changes in the price of an underlying asset.
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Just like there are derivatives based on events in the weather, the price of energy, and inflation rates, there are derivatives based on insurance.
Insurance derivatives are a sort of insurance policy on insurance—if this seems confusing, don't worry, it is.
Insurance products have historically been limited to function as "indemnity" products, which means that the holder of the policy must have some sort of financial stake in the person or item the insurance policy is based on.
For example, a person would not be allowed to take out an insurance policy on the Empire State Building unless he had some sort of tangible pecuniary interest in the property. On the other hand, corporations are able to take out life insurance policies on their CEOs because in the event of the death of an executive officer, the company would suffer a material loss in the time taken to find a replacement.
Insurance derivatives are traded on an open market and are not required to serve as indemnity products— the purchaser of an insurance derivative contract is not required to have any pre-existing interest in the underlying asset.
Insurance linked securities function as most other derivatives in that they are essentially a bet on events that will occur in the future. The market for insurance derivatives can be traced back to 1992, when they were first offered on the Chicago Board of Trade. In 2007, the value of insurance derivative contracts that were traded reached $7 billion.
Like all other derivatives markets, there are hedgers and speculators. Hedgers in the insurance derivatives market are primarily made up of reinsurers. Companies known as primary insurance coverers typically offer relatively lower risk insurance solutions – reinsurers fill in the space and often cover the higher risk areas and markets primary insurance companies do not. Reinsurers turn to insurance derivatives in an effort to hedge against this higher risk exposure.
Catastrophe derivatives, or cat derivatives for short, are based on the likelihood that a catastrophic event, be it a hurricane or earthquake, will occur in a specific area over a specified period of time. There is some overlap between cat derivatives and weather derivatives, but the latter are used chiefly by those whose business is dependent on the weather— travel agencies, farmers, etc, while the former is used by insurance companies who evaluate the risk of destructive "act of God" type events.
Cat derivatives are usually classified by their geographic location, the type of disaster or catastrophe, and the attachment point, which is the industry wide level of insured loss. Insurance companies are protecting themselves if the level of industry wide loss is greater than the designated attachment point.
Beyond cat derivatives, there are insurance derivatives based on the performance of insurers in any and all categories. There are health care insurance derivatives which are based on the average industry losses—health care providers sell these derivatives to insurance companies, who face the risk of rising claims costs. The same types of derivatives are sold for auto insurance—they are all ways for insurers to mitigate the risk they take on by providing coverage to their customers.
Insurance derivatives are a great way for insurance companies to hedge against the risk of their coverage portfolio and an important tool for entrepreneurs in the insurance industry to understand.