The frequency and intensity of hurricanes involving the United States is growing. Some feel the jump is the result of climate change, others believe it is due to variations in the strength of ocean circulations. But one thing is for sure, entities such as those in the insurance industry need a comprehensive way to hedge against losses and claims related to storm-related damage and risk. This is where hurricane futures come into play.
We are currently in the thick of it in the United States. The north Atlantic hurricane season begins June 1 and lasts through Nov. 30. Last week, Tropical Storm Isaac made its entry into Florida’s western coast and threatened to upset the Republican National Convention being held in the area before making its way towards the gulf coast.
Savvy companies use hurricane futures and options products instead of, or in addition to, traditional insurance products because hurricane futures and options are an additional way to help insurers and others transfer risk to the capital markets. The products mitigate exposures for named hurricanes and specific regional locations, and also increase insurance capacity in order to insure customers or hedge businesses.
Target users of the products are insurance and reinsurance companies (entities that offer insurance for insurance companies), but also include hedge funds, energy companies, pension funds, state governments and utility companies.
In the example of Tropical Storm Isaac, hurricane futures and options would allow a market participant to take a position on an individual named storm – for example, by buying or selling a product for Tropical Storm Isaac.
A buyer of an Isaac contract might already have coverage through a product such as insurance, but could be looking to buy more coverage because they would otherwise not have enough coverage in the area where Isaac might hit.
Overall, Hurricanes Are on the Rise
The frequency of hurricane storm systems has increased since 1995, notes Christopher Landsea, a meteorologist and the Science and Operations Officer at the National Hurricane Center, a part of the National Oceanic & Atmospheric Administration.
Landsea, who was asked by the Bush Administration years back to speak to the media about the link between hurricanes and climate change after Hurricane Katrina devastated New Orleans, says it appears there is a currently a cycle of hurricane activity driven by the Atlantic Multidecadal Oscillation – a phenomenon that involves changes in the ocean as well as the atmosphere.
Colorado State University researchers Philip Klotzbach and William M. Gray said in a report published in 2009 that there has been a notable increase in hurricane activity due to an increase in strength of the thermohaline circulation in the Atlantic Ocean. This circulation began to strengthen in 1995, at approximately the same time that Atlantic hurricane activity showed a large upswing, Klotzbach said in an interview.
Further, researchers have found the last 10 hurricane seasons have produced 14 out of the 30 costliest systems to impact the United States. Hurricane Katrina in 2005 was responsible for at least $108 billion of property damage and is by far the costliest hurricane to ever strike the country.
The year 2012 marks the 20-year anniversary of Hurricane Andrew, an event which underscored the need for risk management for insurers and reinsurers. On Aug. 24, 1992, Hurricane Andrew made landfall, and devastated a large portion of South Florida. Andrew later landed on the central Louisiana coast on Aug. 26 as a Category 3 hurricane. Hurricane Andrew was the second costliest tropical cyclone in U.S history and killed 23 people in the U.S. According to the Insurance Information Institute, Hurricane Andrew caused $15.5 billion insured losses in 1992, the most expensive storm ever for insurers, with claims costing nearly four times as much as 1989’s Hurricane Hugo.
Risk Mitigation Prompts Invention
At the time of Andrew, it quickly became apparent through an assessment of measures such as catastrophe-risk computer modeling and residential development patterns that home insurers were more vulnerable to significant weather-related claims payouts than many had previously thought. Some of the largest insurers found it difficult to secure the reinsurance coverage they needed to protect their bottom line because reinsurers were unwilling to assume so much risk. To get coverage from reinsurers, insurers agreed to reduce greatly their potential maximum claims payouts from hurricanes by requiring their policyholders to bear a greater share of the cost.
Researchers note that, while the build in historical information over the years (with National Hurricane Center data going back to 1851) aids in the accuracy of storm prediction, it’s not known exactly where storms will hit. Industry and weather watchers contend an increase in hurricanes has fueled innovation in the futures industry.
In 2008, the year of Hurricane Ike, CME started listing hurricane products. Using publicly available data from the National Hurricane Center of the National Weather Service, the CME Hurricane Index (CHI) futures contract uses the maximum wind velocity and size (radius) of each official storm to calculate the potential for damage. The front contract expires when a hurricane makes landfall with the expiration pegged to the CHI. The contract tick size is 0.1 CHI point, which is equivalent to $100.
The product aims to meet the needs of both the derivative trading community and the insurance market while being easily understood by being simple to calculate and based on publicly verifiable data. In addition to insurers, other customers — such as energy companies, pension funds, state governments and utility companies –through use of the products are able to hedge their risk of hurricanes striking in the United States in five areas defined as the Gulf Coast, Florida, the Southern Atlantic Coast, the Northern Atlantic Coast and the Eastern U.S. CME expanded the instruments in 2009 with the introduction of binary options. Of the products available to hedge against hurricane-related risk, CME’s product is one of the few that trades on an exchange.
Opening week for the products was met with a good deal of interest. The day after CME Group launched a new location to the suite of hurricane derivatives, 1,000 contracts of the new product traded. The deal was executed by TigerRisk Partners, a broker based in Stamford, Conn. The counterparties involved in the transaction were believed to be two reinsurance companies. The trade had a maximum payout of $10 million that would be triggered if the CHI values for all storms in 2010 that made landfall anywhere from Florida to Maine exceeded 25 points. To put things into perspective, Katrina in 2005 was at 19 CHI points when the storm hit Louisiana, and Hurricane Rita made landfall at 9.9 CHI.
TigerRisk is an active firm in CME’s hurricane products. In addition to reinsurance companies, Tiger’s clients include companies in the energy and insurance industries who use the products as a way to hedge their exposure to the costs brought on by major hurricanes.
While these companies could use the over-the-counter market to hedge their risk, on an exchange such as the CME, counter-party credit risk is mitigated, says Steve Smith, an associate at Tiger Risk. Smith adds that trade in the CME’s product is also “transparent and open and incontrovertible.”
Although this year’s forecast calls for an average season rather than above average, Landsea contends that hurricane systems “will stay busy” for at least another five or 10 years, and it’s not completely clear exactly when Atlantic basin hurricanes will swing back to a quieter period overall.
And there is something else adding to the urgency of the need for risk hedging. Of concern is that the areas along the U.S. Gulf and Atlantic coasts, where most of this country’s hurricane-related fatalities have occurred, are also experiencing the most significant growth in population.
Indeed, researchers note that what made the 2004, 2005 and 2008 hurricane seasons particularly destructive was not the high frequency of major hurricanes but a high percentage of hurricanes that hit over the U.S. coastline. According to the U.S. Census Bureau, as of July 2011, of the coastal portion of states stretching from North Carolina to Texas — the areas most threatened by Atlantic hurricanes — the population was 37.3 million. To put it in other terms, approximately 12 percent of the nation’s population already lives in these areas.