Question

An insurance company has insured oil fields in the Middle East. Next, it purchasesreinsurance to manage its “tail risk.” How can the reinsurance company hedge some of itsrisks by trading derivatives?

Answer 1

Solution :

The insurance company has insured oil fields so they are exposed to the risk of prices going low as when prices of oil will fall then they have to pay.

Tail Risk: This the risk faced by the investor when prices fall or rise more than three standard deviations from the mean.

Reinsurance companies can hedge the risk by purchasing options contracts on Oil.

Since they are prone to the fall in the price of Oil so they can purchase a put option and their payoff will be

Pay -off = (Strike price - Spot price ) - premium paid

So loss will be recovered by option contract in case of fall in the price of oil