Insurance derivatives are products that investors can buy in the marketplace. They have payment streams based on characteristics of the insurance market. These derivatives, which have been traded since the Chicago Board of Trade introduced them in 1992, give investors more choices to add to their portfolio and give insurance companies more flexibility in the kinds of policies they can write.
Insurance contracts give individuals a way to share risk. People who are worried about experiencing a certain event pay an amount, called a premium, to an insurance company. The company combines the funds and pays claims from that pool. Each person who purchases insurance trades the chance of having to make a large payment for the certainty of making the premium payment. Theoretically, people should only take out insurance policies if their premiums are equal to their risk of incurring the unwanted event over the premium period multiplied by the cost they would incur if the event occurred.
The purpose of insurance contracts is to protect people from unwanted risks, so purchasers of insurance policies must have indemnity. This means if the event occurs, the policyholder must be directly affected; for example, you could not take out flood insurance on your neighbor’s house because you would not be responsible for paying for repairs if flood damage occurred to the house.
Insurance derivatives are not limited to indemnified parties. They allow any investor to buy insurance-based products in the market. Investors who purchase insurance derivatives are often speculators. This means they try to guess at future events and invest accordingly. These products also allow investors to add a new market sector to their portfolios, so they can diversify their investments.
Some insurance companies also participate in the insurance derivative market. Not all risk levels are equal, and insurance companies recognize this. Generally, the people who can get traditional insurance are at a low risk for the insured event. This leaves a group of high risk people who want insurance but cannot buy it, and providers called reinsurers supply insurance to this group. They take on the added risk because they can invest in insurance derivatives to decrease their risk.
There are a variety of insurance derivatives available for trade. They are not based on actual policies; rather, their payments are determined by the levels of insurance statistics. Weather derivatives depend on specified weather events. Cat derivatives make payments based on whether a certain catastrophe happens. There are also derivatives that get their value from the statistics of segments of the traditional insurance market.