This article introduces and analyzes insurance derivatives such as ISO futures and options on futures and PCS options developed by the Chicago Board of Trade, which provide a means for insurers and reinsurers to hedge underwriting losses due to industry-wide shocks, such as natural catastrophes and to efficiently their capacities without holding additional equity capital.
Unlike reinsurance negotiations that are costly, lengthly, and irreversible, insurance futures, call spreads and PCS options have the advantages of reversibility, transactional efficiency, and anonymity because they are standardized and exchange-traded. Besides insurance underwriters, mainstream institutional investors may also enjoy the diversification effect of these derivatives since catastrophic losses show no correlation with the price movements of stocks and bonds.
