Heterogeneous Expectations and Speculative Behavior in Insurance-Linked Securities

Within the framework of heterogeneous agent models, this paper analyzes the impact factors on the issuance of an insurance-linked security (ILS), and gives an ILS pricing formula and the conditions of existence and stability of the issue price. We consider two cases: fixed supply and flexible supply. We find that, in the fixed volume case, to assure the successful issuance of an ILS, an appropriate volume of the ILS is necessary, and to attract investors, the ILS should pay a positive premium which can help investors to enhance the efficient frontier of their portfolio. In the flexible supply case, we show that the issue price of an ILS is given by the weighted average of different beliefs about the discounted ILS return, and the stability of the issue price depends on the numbers of investors and sponsors and the extrapolation rate to the ILS of investors. In addition, whether an ILS has the hedging ability to sponsors depends on their own understanding about the ILS coupon and the relationship between the recovery from the ILS and their liability, but how much the risk of sponsors can be hedged relies on the ILS coupon expected by investors.