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This article describes the forces that drive financial innovation in the insurance industry, as it relates to the convergence between insurance and capital markets. The authors base their analysis on general principles of supply and demand underlying financial intermediation and innovation, e.g., regulation and taxation. They also provide practical examples from both the capital and insurance markets. Finally, the article addresses the costs and benefits of capital markets‐based insurance solutions and inherent challenges to future innovation.

Although much research has been published on the convergence of insurance and capital markets, few researchers have explored the interrelation between capital market and insurance cycles, i.e., the covariation between (excess) capital and the supply of insurance capacity. The article focuses, in particular, on how investment returns restricted capital outflow and thus impaired the influence of capital market discipline on property and casualty over‐capacity during the mid‐1990s. The authors also discuss how certain risk convergence products develop or evolve in response to the insurance cycles.

Derivatives are important risk management tools widely used by financial institutions, including insurers. Insurers rely on derivatives for managing actuarial, market, credit as well as liquidity risks. There is lack of knowledge and publication about the recent use of derivatives by insurers. This paper attempts to fill the gap in the literature.

The paper analyses data based on statutory company filings with state regulators in the USA.

The analysis suggests that derivatives are used by larger companies, especially in the life insurance industry. This could be explained by the significant economies of scale that are possible when using derivatives. Smaller firms do not have the resources to invest in the latest risk management technologies, and management may be uncomfortable using such new tools. Surveys and anecdotal evidence also suggest that, for insurance companies, the lack of familiarity with the regulatory and accounting treatment of derivatives is another reason for their cautious derivative usage.

The main value of the paper is the analysis of derivative usage by insurers based on recent data. The brief description of accounting and regulatory issues concerning insurance industry usage of derivatives, provided in the paper, would be useful to managers in insurance companies considering use of derivatives. The paper would also be useful to market participants interested in providing derivative‐based solutions to insurance companies.