Derivative Reinsurance

The capital and derivatives markets are no strangers to risk. However, there are certain features of insurance risk which are atypical of the risks with which these markets are accustomed to dealing. Perhaps the most fundamental distinguishing feature is that in financial markets, there is no requirement for the risk seller (that is the note issuer or derivative counter party) to have suffered any loss as a condition of the risk buyer making a payment. Nor does the risk seller need any interest in the underlying subject matter as a condition of receiving payment. It is the absence of the insurable interest feature that enables instruments such as credit linked notes to avoid being construed as insurance under English law. Because of this, market participants fall outside the regulatory regime for insurance. 

Equally, not all types of insurance risk naturally lend themselves to a capital markets or derivatives solution. Instruments in these markets have, generally, a certain and final maturity or termination date. A further contrasting feature relates to the mechanism used for determining the measure of loss in respect of a risk. The financial markets are accustomed to measuring loss or gain by reference to established and well understood indices. It is a relatively simple matter in the context of interest rates, currencies, equities and commodities. It is less so in the case of a claim in relation to a specific policy of insurance or reinsurance. Notably, though, the increasing volume of credit risk and credit default instruments is enabling investors to become more familiar with case specific loss measure mechanisms.