Catastrophe Insurance Exposure and Hedging: Structure and Issues

Catastrophe insurance, like most types of insurance, is essentially a protective put option purchased by someone to ensure or lock in the value of some underlying asset, be it a house, car, or health. The buyer pays the insurance company a premium to purchase the policy. If some predetermined event occurs, reducing the value of the protected asset, the insurance company effectively buys or replaces the asset for the policyholder according to the details of the policy. A catastrophe, by legal standards, must be an event causing at least $25 million in damage and affecting multiple parties. To stay in business, an insurance company must collect more in premiums than it pays out in claims every year. Survival is ensured by setting premiums high enough to allow for an expected level of claims.