Why Do Insurance-Linked Exchange-Traded Derivatives Fail?

This paper analyzes the reasons why exchange-traded insurance-linked derivatives like catastrophe insurance futures and options have failed to attract interest from financial market participants. There are various risk components embedded in exchange-traded catastrophe insurance derivatives—namely, basis risk, liquidity risk, and development risk—which may limit their appeal to the hedging and investing communities. Our analysis suggests that the choice of an industry loss index as a trigger for exchange-traded derivatives (and other securitized instruments) may not matter as much as commonly thought, or at least may not be the main reason why insurance linked exchange-traded derivatives fail. Our research also shows that, when analyzing large storm estimates, a long development period may not be as crucial to the success of exchange-traded derivatives. A few academic papers have cited the lack of standardization in the insurance-linked securities (ILS) market, a steep learning curve for both hedgers and speculators, costs and barriers to entry, and inadequate regulation as reasons for the slow development of exchange-traded insurance-linked derivatives. But we also believe that a penalizing margining system and product design issues like those mentioned above contribute to the lack of liquidity in this market. Futures and options exchanges can easily correct these limitations.