Insuring Against Hurricanes

Wednesday, Jul 22,2009, 11:21:52 AM Click:

To hedge against the Big One, buy an exchange-traded hurricane contract.

Despite a quiet hurricane season so far, the capital-starved insurance industry remains nervous. Hurricane Ike caused $11.5 billion in damage last year. State Farm, Florida's biggest home insurer, announced it will phase out its 1.1 million policies there. Florida's state catastrophe fund is supposed to provide $28 billion in reinsurance but has only $10 billion. Reinsurance rates are up 30% this year. It wasn't this tough even after the $24 billion bill from Sept. 11 or the $60 billion bill from Hurricane Katrina.

Is there a better way for insurers to off-load risk onto the capital markets? Here's one small solution that's gaining traction: Last year the Chicago Mercantile Exchange saw the first trading in futures contracts tied to something called the CME Hurricane Index, or CHI. Buyers put up some $10 million in premiums for contracts with $100 million in notional value. Contracts expire at the end of each hurricane season. Interest is up this year, with $40 million in notional value outstanding so far.

As of mid-June a contract that would pay out $10,000 if a Hurricane Katrina-size storm hits the Gulf Coast by Dec. 31 costs $700. Protection from an Ike-size storm hitting Florida costs $3,800. Why the price differential? Probabilities. Monster storms like Katrina are rare, while Florida gets hit often.

So far primary buyers are reinsurers or oil companies seeking to protect rigs in the Gulf of Mexico. But hurricane-prone areas like Florida's Dade County are exploring them, and the contracts could even work for homeowners who have seen insurance rates soar on oceanfront mansions. A minimum trade is 20 contracts. Hedge funds are the main sellers of insurance protection.

The hedgies wouldn't be willing to take on this risk if not for the CHI, which employs a new method of categorizing hurricanes, using both wind speed and size to quantify a storm's potential to inflict losses. It's a huge improvement over the Saffir-Simpson scale, which ranks hurricanes 1 through 5 solely on wind speed but is close to useless in predicting damage. Ike was only a cat 2 on Saffir-Simpson, but its 240-mile diameter made it the second-most-costly storm in a decade. Ike rated 9.9 (Katrina scored a 19) CHI points. Eqecat, a risk-modeling consultancy, calculates storms' index values for the CHI, using data from the National Hurricane Center.

Contracts come in a variety of flavors. You can get coverage against a storm of specific size hitting one of seven geographic areas. Or you can bet on the severity of the season. Convinced that four Ike-size storms are brewing? You might buy a "seasonal aggregate 40" contract--$2,500 premium for a payout of $10,000 when the CHI values of the season's named storms surpass 40 points.

Then there are contracts tied to individual storms. Trading in these will pop when Ana, Bill and Claudette (this year's names) form. CHI values and contract pricing for name storms will be updated constantly until the storm has made landfall. Trading will continue until the contracts settle, usually within 36 hours of landfall.

Kendall Johnson at Tradition Re, an interdealer brokerage that has so far handled 100% of the Merc's hurricane trades, says that a common trade is for a hedge fund to sell hurricane call options to a reinsurer or an oil company, then use the premiums to buy out-of-the-money calls on natural gas, which tends to spike in price when a hurricane sweeps the gulf.