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HMRC internal manual

General Insurance Manual

From
HM Revenue & Customs
Updated
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Reinsurance and other forms of risk transfer: financial reinsurance and alternative risk transfer (ART): derivatives

Derivatives and other products of capital markets offer risk transfer methods or risk finance, with close similarities to insurance and reinsurance. Insurance futures and options first appeared on the futures exchange run by the Chicago Board of Trade (CBOT) in 1992. Strictly, the original CBOT insurance futures were contracts for difference. They were based on indexes that measured the loss ratios for defined lines of insurance business in particular geographical areas. For example, one of the CBOT contracts (Eastern Catastrophe) was based on the quantum of incurred losses from wind, hail, earthquake, fire and riot along the eastern seaboard of the United States from the Gulf of Mexico to the Canadian border. A subsidiary of the CBOT constructed the index (the loss ratio of incurred claims to earned premiums, expressed as a percentage) each quarter from reported statistical and actuarial information.

For example, if the market expects an average loss ratio of 40 per cent from, say, hurricanes in particular area, an Eastern Catastrophe future would start trading at a price of 40. If the actual claims experience from the defined perils turns out to be 65 per cent, the index which fixes the price when settlement is due would be 65. An insurer writing premium income of $25m would expect claims of $10m ($25m x 40 per cent) on average, but the claims would turn out to be $16.25m ($25m x 65 per cent). However if the insurer bought, say, one thousand Eastern Catastrophe futures at the standard multiple of $25,000, it could expect to make a gain of $6.25m, which would balance the insurance loss it could expect to incur over and above the anticipated claims of $10m. The gain would be calculated as follows:

 

Settlement value 0.65 x $25,000 = $16,250
     
Cost 0.40 x $25,000 = $10,000
Profit   = $6,250
1000 contracts x $6,250 = $6.25m    

 

 

An insurer who buys such contracts can thus balance the insurance loss that it will have incurred over and above the industry expectation. This will not provide a perfect hedge unless, very exceptionally, its own loss experience is exactly the same as the industry expectation. And it must also purchase its contracts in good time, because once the bad weather starts to occur the traded price of the contract will begin to rise. In fact the early versions of the CBOT contracts did not provide insurers with the sort of hedge that they were expecting against losses from the California Northridge earthquake in 1994.

 

The market has continued to develop, more especially in the form of options over insurance futures. At the CBOT both put and call options over the futures contracts are traded, for strike prices within a range either side of the current trading price of the underlying future. If the insurer in the above example had decided that it was willing to carry the risk that the claims ratio might rise above 60 per cent, it could have reduced the overall cost of its hedge by selling call options at a striking price of 60 when it bought the futures contracts. This combination would have much the same economic effect as a layer of non-proportional reinsurance.

A catastrophe option may, for example, be offered on the risk of damage arising from a hurricane in Florida. An insurer can buy a call spread contract, under which options will be exercised to buy and sell contracts at different prices simultaneously, if losses from the hurricane exceed a certain level. The spread provides the option holder with a fixed profit (the difference between the prices at which the contracts are bought and sold) at a fixed cost (the option premium). Such constructs may be used as an alternative or an addition to conventional reinsurance, and insurers have become substantial buyers of complex structured products.

Weather derivatives are an example of a financial product which can be traded on either the insurance or capital markets. Nevertheless, differences between the two markets remain. Traditional insurance aims to address a specific client need, whereas a capital market instrument is, at least in part, designed to be traded on a secondary market. A capital market product may enable the purchaser to make a profit, whereas an insurance product only provides reimbursement of the loss suffered, not a profit: this is a reflection of the insurance indemnity principle (GIM1060).