Insurance derivatives - A new asset class for the capital markets, and a new hedging tool for the insurance industry

The number and severity of natural catastrophes has increased dramatically over the last decade. In order to expand the capacity of the insurance and reinsurance market, non-traditional forms of reinsurance capacity such as hedge funds, pension funds and commodity funds have to be tapped. Thus insurance risks must be transformed into securities and derivatives that investors can understand and therefore include in an investment portfolio. These financial instruments must also be effective hedging and risk management instruments that the insurance industry is willing to use. This chapter shows how catastrophe-linked options and bonds are financial innovations that have the potential to meet these needs and therefore to bridge the gap between the capital and insurance market.