The Trading of Underwriting Risk: An Analysis of Insurance Futures Contracts and Reinsurance

Abstract

cost associated with the activity. Insurers who have made investments in developing a customer base may wish to protect the quasi rents earned on these investments from insolvency. In essence, the loss of quasi rents is a bankruptcy cost. 21 An exception to this statement is that, because of limited liability, insurers who are close to insolvency may have an incentive to go for broke and therefore increase risk. 22 The parameter b/2 in the value function measures the insurer's variance related costs per unit of variance. The per unit cost of variance is likely to depend on the amount of The Chicago Board of Trade (CBOT) is expected to introduce a futures contract on a pool of homeowners insurance policies in late 1992 or early 1993.(1) Contracts based on other lines of insurance, including group health and auto physical damage, are under consideration. These contracts are based on the underwriting losses of a large pool of policies; accordingly, futures allow for explicit trading of the systematic underwriting risk within a line of insurance, that is, the underwriting risk that cannot be diversified away by writing policies in one line of insurance. The trading of underwriting risk via a futures market represents a departure from the bilateral trade of underwriting risks typically observed in the reinsurance market to the anonymous trading of a contingent claims market. One objective of this article is to analyze insurance futures contracts versus reinsurance contracts as alternative methods of trading underwriting risk. An important distinction between these contracts is the manner in which they mitigate incentive problems that arise when underwriting risk is traded. Reinsurance contracts are based on the underwriting losses of a pool of policies written by the ceding insurer. Consequently, an incentive problem arises: The more risk that is shifted to a reinsurer, the less incentive the ceding company has to select low risk policyholders and to reduce loss claims. Reinsurance market participants recognize these incentive problems and attempt to control them through incomplete risk shifting; for example, by using deductibles, coinsurance, contingent prices, and experience rating. Futures contracts provide an alternative way of mitigating the incentive problem associated with trading underwriting risk. Futures payoffs are based on only the systematic risk within a given line of insurance. Because underwriting losses due to systematic factors are largely outside the control of insurers, futures contracts potentially allow for complete risk shifting of the systematic underwriting risk inherent in the policy pool on which the futures contract is based. Another distinguishing feature of futures markets is the reduced need for contracting parties to monitor the creditworthiness of other parties. Default risk is negligible with futures, because traders post performance bonds (margin) and because the clearinghouse guarantees performance on futures transactions. The reduced need to monitor other parties allows systematic underwriting risk to be traded anonymously (see Telser, 1981). Consequently, a futures market can enhance liquidity in the market for trading underwriting risk. To assess whether greater liquidity is a meaningful innovation, the factors affecting insurer demand for liquidity and the cost of providing liquidity services in an insurance futures market are analyzed. The second part of this article presents a model of an insurance futures market to analyze how unregulated insurers are likely to use insurance futures, the determinants of insurance futures prices, and the impact of insurance futures on the primary insurance market. An important implication of this analysis is that the extent to which insurers will use futures to hedge underwriting risk is contingent on the value of the equilibrium risk premium embedded in insurance futures prices. This risk premium depends on the compensation necessary to induce market participants to bear underwriting risk that is systematic within a given line of business. …