Hurricane relief
Weather derivatives offer some advantages over CAT bonds
By Michael J. Moody, MBA, ARM
The past few years have been favorable to the U.S. catastrophic property underwriters, but how long can that continue? It was just 2005 when we were pummeled by the three sisters, Hurricanes Katrina, Rita and Wilma. Total losses in 2005 were estimated at $54 billion, and when combined with 2004 losses, the total balloons to over $75 billion. At this point, it is clear: Hurricanes present a unique challenge for the property insurance and reinsurance market.
There have been several attempts to provide innovative solutions for this catastrophic exposure. One of the more successful innovations has been CAT bonds, which over the past few years have become a valuable source of contingent capital for property underwriters. More recently, sidecars have been an additional source of capital that can be deployed quickly and efficiently in a time of need. Both of these alternatives have found their supporters, but each also has some significant shortcomings that limit their use. However, there is another alternative risk transfer (ART) product that has been recently been developed that may provide a long-term solution to the critical risks of hurricane.
Historical perspective
Interest in weather risk management in general has been growing. With projections by the Department of Commerce indicating that as much as one-third of all U.S. commerce is directly touched by weather, it has become a major issue for many companies nationwide. One of the early ways to hedge the effects of weather has been the use of weather derivatives. And an early proponent of this effort has been the Chicago Mercantile Exchange (CME). (See “Help for CATS,” April 2007 issue, page 80.) The Exchange was actively involved in the development of a number of temperature-based index futures and options specifically designed to help hedge weather-related risks. This market has grown over the past few years and is now geared to seasonal and monthly weather conditions in 18 U.S., nine European and two Asia-Pacific cities. The primary product quantifies weather in terms of degrees above and below monthly and seasonal averages.
Based on the earlier efforts with weather-related risk management, it was only natural that the CME would be interested when it was approached by insurance/reinsurance intermediary Carvill. Carvill had developed a new approach to weather-related derivatives. It had developed a unique approach to address the risks posed by hurricanes in the United States. While the concept was of interest, an early issue surrounded the use of the current Saffir-Simpson Hurricane Scale.
Saffir-Simpson uses a classification of hurricanes into categories from 1 to 5, and while it is frequently used in the insurance industry, this measurement did not lend itself to being used for exchange trade derivatives. As a result, Carvill had to establish its own scale, the Carvill Hurricane Index. According to Carvill, the challenge was to develop an index that met the needs of both the derivatives trading community and the insurance market. Above all, it needed to be easily understood, simple to calculate and based on publicly verifiable data—in short, an index that is transparent.
Early attempts
According to Dr. Steve Smith, president of ReAdvisory’s Property Solutions, Carvill’s analytical arm, the hurricane derivative was actually introduced last year. He points out, however, that during the past year, there has been some fine-tuning of the product. “Over the past 12 months we have been reviewing the things that worked and the things that didn’t work,” he says. For example, initially they had five overlapping regions limited to the Atlantic and Gulf coasts in the U.S. Recently, they added an important sixth region. Smith says it is called the “cat-in-the-box” region and it runs from Galveston, Texas to Mobile, Alabama. The importance of this region, he points out, “is that it encompasses the majority of the offshore oil rigs.”
Another important modification has been the ability to either do the deal as a typical derivative or as a reinsurance contract. According to Smith, being able to offer these as a reinsurance contract has one overriding advantage: “being able to keep the rating agencies happy.” This change will allow reinsurers to take full credit on their financials for a reinsurance transaction. Smith also points out that this option goes a long way toward appeasing regulators as well, since regulators rarely gave full credit for derivatives. Smith notes that this single change should make the product much more acceptable to the reinsurance community.
Carvill can offer this transaction as a reinsurance contract due in large part to the use of a Carvill-owned Bermuda captive, known as Mount Prospect, Ltd. Smith says that Mount Prospect is a transformer, and it is “the vehicle whereby we can issue a reinsurance policy backed by the derivative.” Another important party to these transactions is Deutsche Bank, which will provide Standard & Poor’s AA rated security that is responsible for formally transforming the derivative into a reinsurance contract.
Further refinements
There are a number of products, most notably CAT bonds, that can offer reinsurers a different approach to providing catastrophic property protection. But derivatives and CAT bonds differ in several key areas. One of the most significant differences has to do with the time to consummate the deal. Typically, CAT bonds are entered into prior to hurricane season, and they may have a contract term that runs two to three years.
The hurricane derivatives can also provide for annual coverage via a “seasonal aggregate contract” and a “seasonal maximum contract.” However, it is the shorter duration contracts that are gaining favor, according to Smith. These shorter term contacts, called “event strip contracts,” are basically traded as “line CAT” products during the lifecycle of a storm. Smith indicates that these contracts have been of interest to the oil and gas industry, which wants to have coverage that is written as essentially “named storm contracts.” This way, he says, “When the storm either goes away or makes landfall, you settle that contract.”
The settlement feature noted above is an additional plus for the hurricane derivative product. Settlement of CAT property losses has been difficult, but the derivatives are resolved quickly. If you buy a “named storm” contract for example, Smith points out, “you get your money three days after the storm makes landfall.” In the case of our seasonal products, he says, “you will get your money three days after the end of hurricane season.” Smith notes that this is an important feature for most customers, but he points out it is critical for customers like wind pools, because “they can get their hand on the money in three days and begin paying their insureds quickly.”
For the most part, 2007 was a learning year for the product development team. But, Smith advises that they are heading into 2008 in a much better position. As a matter of fact, he says, “we already have our first customer.” He points out that they have sold their first hurricane derivative, “that was around $13 million, and was written as an annual contract that was split between Florida and the Northeast.” And after spending so much time perfecting the reinsurance alternative, the first deal was a straight derivative contract. It was also a record setter “for a first time trade of a new product on the CME.”
Conclusion
Innovation within the insurance industry is sometimes lacking. Over and above that innovation issue, as an industry, we continue to fight tooth and nail the idea of convergence with the financial markets. But now, it is apparent to most industry observers that our exposure to catastrophic property losses is just too great. Accordingly, it is time to begin to take advantage of the capital markets, and the new hurricane derivative product is one of those innovations that should receive our attention. Large property underwriters should take a serious look at the features of these products and see how they can be utilized in their reinsurance portfolio. *