INSURANCE FUTURES AND HEDGING INSURANCE PRICE RISK

This article discusses the Chicago Board of Trade's proposal to establish a market for futures contracts (and options on futures) written on insurance business. A European call option on an insurance future is equivalent to a stop-loss reinsurance contract on the portfolio of insurance policies underlying the futures contract. Put options correspond to the discounted expected value of retained losses. After a credible experience record is developed, an insurer can determine the correlation of its own portfolio of policies with the market portfolio and use the futures options market as a partial substitute for traditional stop-loss reinsurance. The advantages of such a market are that it provides a tool for hedging business risk, it allows an entity to participate in the market portfolio's profitability without being a licensed insurer, it may have lower transactions costs than traditional reinsurance, and it provides a mechanism for price discovery. But, despite the advantages of an insurance futures market, there are serious barriers to its success, which are discussed briefly.