A Buyer's Guide for Options on a Catastrophe Index

In the wake of recent catastrophes, a new way of transferring insurance risk was born. In December 1992, the Chicago Board of Trade began trading contracts on an index sensitive to insurer catastrophe experience. Such indices provide an insurer a means to transfer a portion of its catastrophe risk to the capital markets by buying future and option contracts. The cost of using these contracts to transfer catastrophe risk is compared to the cost of raising sufficient capital to retain the risk and the cost of conventional reinsurance. We derive equations that give the optimal participation in the future and option contracts, and in reinsurance. The cost of using these contracts can be compared to the cost of the capital that they replace.