Comparison of Derivatives and Insurance Contracts

Comparison of Derivatives and Insurance Contracts

An insurance contract can be viewed as a derivative contract where the underlying asset is the value of losses experienced by the insured.

There are both similarities and important differences.



Market Value

Specific Losses

Used to hedge risk arising from unexpected changes in market prices

Hedge risk arising from losses specific to the insured

Options and futures of interest to hundreds of companies that use commodities

An insurance contract derived from liability or property would be specific to only one firm

Basis risk and extent or risk reduction, basis risk is the uncertainty about effectiveness of a hedge.

More Basis Risk

A firm may experience a drop in profits as derivatives may have lower payoff

Less Basis Risk

Little uncertainty about quality of hedge, ignoring insolvency

Contracting Costs

Less because of moral hazard and adverse selection. Individuals cannot influence the payoff.

Outside influence of individual firms results in less costs for investigation and monitoring


Loss payoffs influenced by the actions of the insured party. Moral hazard more severe.

Firms have more information about expected losses creating adverse selection. Must incur cost to investigate and monitor.

Capital Costs

Bring together user and producer and reduces price risk for both.

Do not have to physically trade the commodity.

Lower since the matching parities with negatively correlated exposures

Losses experienced by one firm do not trigger a simultaneous gain by another.

Losses tend to be independent or perhaps positively correlated across firms.

From insurance company standpoint, risks reduced thru diversification.

Sell to many different policyholders creating higher marketing and underwriting costs


A small amount of capital needed

To ensure contractual performance. Derivatives will require a payment

Only when firms cash flow otherwise Would be high

Insurers have to hold capital to pay claims and this cost is an additional cost.

Must also hold capital to satisfy policyholders



Large numbers affected by prices

Lower transaction costs

Firm can quickly establish a hedge

Liquid market

Buy or sell quickly


Modification to provide more of less coverage can take time and create expenses

Illiquid market

Must wait for someone to pay asking

Price or lower price

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Knowledge Thailand ,Knowledge Thailand,Knowledge Thailand
Knowledge Thailand ,Knowledge Thailand,Knowledge Thailand
Knowledge Thailand ,Knowledge Thailand,Knowledge Thailand
Knowledge Thailand ,Knowledge Thailand,Knowledge Thailand.
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