When is a CAT Index Futures Traded and Preferred to Reinsurance? – Tradeoff Between Basis Risk and Adverse Selection –

Abstract

Insurance risks have traditionally been borne in reinsurance markets. However, in the 1990s, after a series of huge natural disasters, and consequently massive insurance payments, the reinsurance markets reduced their capacity to bear risks. Insurance-linked securities, such as CAT (catastrophe) index futures contracts, were created to provide insurers with a way to transfer insurance risks to capital markets. However, two obstacles are preventing CAT index futures from being traded: the basis risk between insurers’ risks and the futures payoff, and adverse selection between informed insurers and uninformed investors in capital markets. This study investigates the conditions under which CAT index futures, whose payoff is the average of insurers’ losses, can be traded, and insurers choose CAT index futures rather than reinsurance to transfer their risks. The results show a trade-off: CAT index futures can be traded if the number of insurers in the index is large enough, since averaging multiple insurers’ losses can mitigate adverse selection in the index futures’ payoff. However, if the number of insurers in the index is too large, insurers prefer reinsurance to index futures due to the high basis risk in the futures’ payoff.