An insurance derivative is a financial instrument that derives its value from an underlying insurance index or the characteristics of an event related to insurance. Insurance derivatives are useful for insurance companies that want to hedge their exposure to catastrophic losses due to exceptional events, such as earthquakes or hurricanes.
Unlike financial derivatives, which typically use marketable securities as their underlying assets, insurance derivatives base their value on a predetermined insurance-related statistic. For example, an insurance derivative could offer a cash payout to its owner if a specific index of hurricane losses reached a target level. This would protect an insurance company from catastrophic losses if an exceptional hurricane caused unforeseen amounts of damage.
Another example of an insurance derivative would be orange growers in Florida, who rely on derivatives to hedge their exposure to bad weather that could destroy an entire season’s crop. The orange growers purchase derivatives that allow them to benefit if the weather damages or destroys their crop. If the weather is good, and the result is a bumper crop, then the grower is only out the cost of purchasing the derivative.
Though insurance-like in behavior, weather-based insurance derivatives are fundamentally different from traditional insurance. Generally, both are avenues to transfer risk in exchange for premium payments. However, weather-based insurance derivatives anticipate high-probability, low-risk events (i.e., weather fluctuations) and cover concentrated or singular risks.
By contrast, traditional insurance usually anticipates low-probability, high-risk events and is more comprehensive in coverage. Moreover, derivative premiums and payouts are determined by the market value of the underlying asset not by the probability of a loss event occurring (as is the case with insurance).
Insurance Derivatives vs. Traditional Insurance
One advantage of using derivatives in place of insurance is that the hedge is more protected from spatially correlated events such as adverse weather patterns. If, for example, a heat wave moving across the western United States stops electricity production at wind farms in those states, project owners may have little recourse in the geographical diversity of their portfolio. Derivatives afford project owners access to the risk sharing of financial markets, and this kind of diversification can be better than that of geographical distribution.
Another good point about insurance derivatives is the settlement process is typically quicker and less onerous than it is for traditional insurance. Derivatives pay out instantly, triggered by the movements of an index, which requires no interpretation. An event either happens, or it doesn’t. Insurance claims, on the other hand, aren’t so black and white, and they can incur considerable processing time and costs.