Disaster Derivatives Set to Grow in 2008

April 1, 2008

With the United States bracing for big hurricanes this year, new derivatives to trade catastrophe risks offer insurers the extra protection they crave against multi-billion-dollar storms.

Trading of “catastrophe derivatives” has begun on several exchanges, allowing insurers to hedge exposure in the same way banks turn to credit default swaps to hedge credit exposure.

“We could potentially envision that in five years insurance companies would have trading desks (for) their insurance exposures, just as today banks have trading desks (for) their currency, interest rate or equity exposures,” said Jay Ralph, the CEO of Allianz’s reinsurance business.

One of the leading exchanges, The Insurance Futures Exchange, saw more than 3,100 contracts traded between when it began operating at the end of September 2007 to early January 2008.

Catastrophe futures are also being traded on the Chicago Mercantile Exchange (CME) and NYMEX, while the world’s largest reinsurer Swiss Re and Deutsche Bank have become heavily involved in the fledgling market.

ICAP, the world’s largest interdealer broker, has launched a joint venture with insurance broker Jardine Lloyd Thompson to originate, structure and act as broker on insurance-related securities.

ICAP’s CEO Michael Spencer told Reuters in November: “it strikes me that the insurance market has many, many characteristics which suggest it would benefit from the arrival of derivatives.”

Derivatives trading worth tens of millions of dollars is tiny compared to premiums of around $100 billion in the traditional reinsurance market, but for the first time insurers can actively trade what for many is their biggest exposure. Derivatives also have an advantage in offering instant liquidity. They pay out in a matter of days, whereas a reinsurance contract can takes months to settle. Firms can even buy or sell coverage for hurricanes as they gather strength and churn towards the U.S.

This is a far cry from the traditional reinsurance market, which has changed little in its 160-year existence offering insurers year-long contracts that effectively insure them against heavy claims.

Reinsurers offer insurers only a few short windows, at the start or the middle of the year, to buy enough capacity to protect themselves against the coming hurricane season. But the cost and supply of reinsurance fluctuates wildly according to market events, particularly in the case of big disasters.

In 2006, the year after the costliest ever hurricane, Hurricane Katrina, hit the United States, there was a $40 billion black hole between the hurricane cover that insurers wanted to buy and what reinsurers were willing to offer, said John Cavanagh, Chairman of Carvill Re, a reinsurance brokerage. “The reason for that is that we’re a feast or famine market. We don’t have a deep and liquid secondary market that we can tap into when the market is hit with a big capital outflow.”

Many U.S. insurers were unable to buy enough reinsurance cover and were left with their fingers crossed, hoping that 2006’s hurricane season would not be as bad as the previous year. In the end 2006 passed quietly, but a string of firms could have gone bust because they lacked the reinsurance to withstand heavy claims from big storms, analysts said.

Carvill is one of a number of companies to have developed catastrophe derivatives to try to plug this capacity gap. It has launched a set of derivatives in partnership with TFS, part of the world’s third largest interdealer broker, which are traded on the CME.
“If we can bring more capacity to the market through indexation and standardization, then I think that will deliver a more stable and consistent product to our customers. That, in turn, will bring more consistent pricing,” said Cavanagh.

Derivatives allow insurers to buy cover from a new pool of investors, including energy traders wishing to hedge the price of oil or gas against a hurricane-induced rise or simply speculators such as hedge fund willing to bet on storms.

The CME has already posted trading information on the first three storms of the 2008 hurricane season. Speculators may trade on them now, taking a punt that the first storm will follow historical patterns and be only a mild one, said Cavanagh.

Despite expectations that catastrophe derivatives will grow rapidly, even some who trade them are skeptical that they will allow insurers access to a vast pool of new capital.

Trading volumes are unlikely to reach the levels seen in other markets, such as energy or commodities derivatives, where billions of dollars change hands every day, said Barney Schauble, a partner at Nephila Capital, a Bermuda-based hedge fund specializing in insurance risk.

“Players have to be realistic about what they can expect in terms of liquidity. If you’re going to sell protection you have to be prepared to own that until it expires,” said Schauble.

“Insurance derivatives could expand the marketplace in that they open further sources of capital to this business,” said Elke Koenig, CFO of Hannover Re, the world’s fourth largest reinsurer. “But it just would not replace the tailor-made reinsurance market.”
But that isn’t their point, said Cavanagh. “We see these as a complement to what you can buy in the traditional market.”

By Simon Challis and Jonathan Gould

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