Academic journal article Journal of Risk and Insurance

Insurance Futures and Hedging Insurance Price Risk

Academic journal article Journal of Risk and Insurance

Insurance Futures and Hedging Insurance Price Risk

Article excerpt

Introduction

In May 1990 the Chicago Board of Trade (CBOT) announced a novel insurance futures contract designed to allow the insurance industry to hedge business results. We develop a valuation model for the proposed futures contracts. The model incorporates some features used in popular models for financial futures and options markets, such as the well-known Black-Scholes (1973) option pricing model and the Black (1976) futures option pricing model.

There are three insurance futures contracts under consideration by the CBOT, each pertaining to a different line of insurance: health, homeowners,(1) and catastrophic property damage.(2) Options on these futures are also under consideration. In addition, futures markets for marine insurance are being developed in London. Because of possible competition, only general information is being provided to the public until the proposals are approved by the Commodities Futures Trading Commission.

Preliminary announcements by the CBOT indicate that an insurance futures contract would be based on a pool of qualifying policies representing a national cross-section, and a new policy pool would be compiled each January.(3) Demographic information and other aggregate policy characteristics will be published upon pool formation. Qualifying policies must originate in the month of pool formation and must have fixed premiums over the first year. Qualifying insurers will be anonymous, and no insurer may comprise more than 15 percent of the pool. The CBOT will designate a pool manager (e.g. a statistical agent such as the Insurance Services Office) to establish the pool and monitor aggregate premium and claims activity.

We describe the value upon which the futures contract is based in more detail below, but for our introductory discussion it is sufficient to define it as 100,000 |center dot~ LR, where LR is the loss ratio (paid claims divided by earned premiums).(4) A futures trader who believes current insurance futures prices are low would buy insurance futures. No cash outlay is required, beyond establishing a margin account. The trader merely notifies a broker and pays a small transaction fee. As the futures price increases, the buyer's margin account is credited with the increase. If the futures price decreases, the trader's margin account is drawn down correspondingly. Margin accounts are adjusted for gains and losses on a daily basis. A trader who expects a price decline would sell insurance futures.

Although the contract is ultimately settled on the basis of actual claims and premiums, the day-to-day settlement prices are determined by market consensus--the same way the more familiar commodities markets work. But, unlike the more familiar commodities futures, insurance futures obligations cannot be settled by delivery of a commodity. Insurance futures are similar to the very successful futures written on stock price indices. In the case of a futures contract written on a stock price index, the futures obligations are settled in cash on the basis of the stock price index value at the time the futures contract matures. The value of 100,000 |center dot~ LR plays the same role for insurance futures that the stock price index plays for stock price futures. Thus, information about claims payments will be very important to insurance futures traders.

Each month, until the last contract expires, insurers participating in the pool will report their premium and claims activity to the statistical agent, and this information, in aggregate, will be made public. Other events will also have an impact on futures prices. For example, a hurricane might have an impact on homeowners insurance futures prices. We can expect insurance futures prices to vary from day to day just as the more familiar futures prices of commodities and financial instruments do, even though actual data will be reported only once a month. The mark-to-the-market mechanism will be used to pass these market value changes to buyers and sellers daily based on each day's closing price. …

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