Pricing Catastrophe Risk: Could CAT Futures Have Coped with Andrew?

Insurance futures and options have been trading on the Chicago Board of Trade since December, 1992. This paper describes these derivative instruments, explains how they have changed over time, illustrates trading volume and price levels, discusses the safety of the financial guarantees backing these contracts, analyzes trends in catastrophe losses, summarizes the literature relating to insurance derivatives and briefly describes some additional capital market securities that attempt to deal with catastrophe risk. We suggest that if derivatives were widely used to cope with catastrophe risk, then a disaster the magnitude of Hurricane Andrew would have severely stressed the financial markets, possibly leading to significant defaults. If the insurance industry is not successful in coping with catastrophe risk in some manner, either through insurance derivatives or other means, then more drastic steps, as outlined in this paper, will have to be taken to cope with this risk to avoid widespread insurer insolvency when a devastating catastrophe next occurs.