Back to the futures: capital markets and insurance continue to blend together with the resurgence of catastrophe-linked futures.

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The market for catastrophe-linked options and futures is taking off, giving insurers and the capital markets another avenue to transfer risk.

Unlike traditional reinsurance, you don't need an underlying insurable interest--a loss--to collect on a cat future. And you don't need to be a licensed insurer to take on the risk.

Currently, several different contracts are trading on three different exchanges. Gallagher Re created the Re-Ex Index, against which the New York Mercantile Exchange Inc. catastrophe risk derivatives are settled. The cat risk index futures and options contracts are aggregate contracts and were first listed and began trading in March 2007, using Property Claim Services estimates as the foundation of its index.

The index futures refer to three areas: U.S. nationwide, Texas to Maine excluding Florida, and Florida. The contracts are listed for loss-years 2008, 2009 and 2010. The contracts expire on the last business day in March following the calendar-year loss.

Insurance Futures Exchange Services Ltd., a member of the Climate Exchange Plc group of companies, and Deutsche Bank AG began trading in catastrophe event-linked futures on the Chicago Climate Futures Exchange in September 2007.

"ELF contracts will offer investors the ability to trade natural catastrophe loss risk outside the framework of conventional insurance and reinsurance contracts, as well as provide hedging contracting capability for property/catastrophe insurance-linked exposure," IFEX said in a statement.

Carvill has developed the Carvill Hurricane Index, which is used as the basis for hurricane risk futures and options listed on the Chicago Mercantile Exchange. Carvill has several types of contracts available, including those that would cover:

* Named storms, which allow investors to take a position on the CHI value at landfall for a specific storm;

* Seasonal maximum, which allows investors to take a position on the maximum CHI value of all storms during a hurricane season;

* Seasonal aggregate, which would allow investors to take a position on the aggregate CHI value of all storms in a season.

The seasonal maximum contract is similar to a first-event, industry-loss warranty, said Steve Smith, president of property solutions for Carvill's ReAdvisory. The seasonal aggregate contact is effectively a "stop-loss" contract, said John Cavanagh, joint chief executive officer of Carvill.

The three contracts are listed for six geographical regions: entire U.S. coast from Texas to Maine; Gulf coast; Florida; Southern Atlantic; Northern Atlantic; and the so called "cat-in-a-box" region covering the offshore oil fields in the Gulf of Mexico.

The named storm contracts are settled three days after hurricane landfall. Seasonal contracts settle three days after the end of the hurricane season. Carvill also launched the futures in March 2007.

New Market Dawns

Just as investors can trade options and futures against commodities such as oil and gas, investors are looking to diversify their portfolios by taking on insurance risk, without having to write a single insurance policy.

Insurers can buy and sell cat futures to balance their risk portfolios. Trading is anonymous, so no one knows who is selling or who is buying the contracts, which can be traded on a daily basis, with the price also fluctuating on a daily basis.

Cat futures "have the potential to take off in terms of volume," said Al Selius, head of insurance-linked securities trading for Swiss Re, which has become an IFEX marketmaker. While the markets are still relatively small, the interesting part of the exchange-traded platform is "it's amazingly easy to transact on them," Selius said. "Once everyone gets comfortable with the terms of the exchange, they'll really take off."

Martin Bartell, a partner with Gallagher Re who played an instrumental role in establishing the Re-Ex Index, said, "If we had a dollar for every time anyone said 'we really like these contracts' but want to see some liquidity before they start trading. It's a little bit of the chicken and the egg." Aon Corp., parent of Aon Re Global, the largest global reinsurance broker according to Best's Review's Top Global Reinsurance Brokers ranking, announced plans in February to acquire Gallagher Re, the ninth-largest global reinsurance broker.

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The contracts are based on aggregate losses in a calendar year, while industry loss warranties, a type of insurance or reinsurance contract that can be triggered based on an industrywide loss, are typically single event covers. Unlike catastrophe bonds, which are tailored to meet the risk of a specific insurers' book of business, cat futures are tied to industry losses as a whole.

"It gives insurance companies and reinsurance companies an ability to hedge their risk by creating more trades--a fluid market as opposed to a cat bond," said Gary Kerney, assistant vice president of Property Claim Services. "They are starting to grow a secondary market where investors can move in and out of those [futures] ."

Deja Vu 

This isn't the first time cat-linked futures have been attempted. In 1990s, the Chicago Board of Trade launched cat options and futures tied to PCS estimates, but the market never took off.

"Insurers didn't understand options, and there was very little trading," Kerney said.

"Hedge funds are much more active in the reinsurance marketplace than they were 15 years ago," Bartell said. "The buyers are more sophisticated."

Those former futures contracts had two strikes against them: They included earthquake risk and were traded in a pit instead of electronically.

"Today, NYMEX can adjust margins on an hourly basis if a hurricane is forming in the Atlantic," Bartell said, "whereas an earthquake occurs with no warning and traders could be hit unexpectedly with a $50 billion earthquake loss. Because of this, people really looked to close out positions every evening [in the 1990s cat future market], which stopped the market from really getting going."

Another draw for hedge funds to the new cat futures market is better margins, Bartell said.

In recent years, some hedge funds have taken on catastrophe reinsurance risk by offering fully collateralized policies. Trading futures is a way for them to take on catastrophe risk by just collateralizing an initial margin of 30 cents on the dollar.

"We'd argue it's more cost effective. Plus they understand the futures and options world fairly well," Bartell said. "Banks and hedge funds are all very keen to trade these contracts. They feel the reinsurance market has an edge over them at present because [reinsurers] understand cat risk better than [bankers and hedge funds] do."

Poised to Grow

The market for cat-linked options and futures is small, but poised to grow tremendously as it competes with traditional reinsurance, experts said.

Selius expects cat futures will join cat bonds as an alternative to traditional reinsurance; some insurers may use all three.

The insurance market is the only major financial market left without a deep secondary market, Carvill's Cavanagh said in a statement.

"As has been seen in other markets, once there are standardized indices and contracts which are posted on exchanges, deep secondary markets rapidly form. Moves toward electronic trading would only speed up this process," Cavanagh said.

He said that last year, Chicago Mercantile Exchange weather products (heating and cooling degree-day options and futures) traded a notional $26 billion on the exchange, up from less than $1 billion in notional value of weather contracts three years ago.

"More industries and users are exposed to hurricane risk than to the sort of 'bulk weather' risk managed by weather derivatives," said Carvill's Smith in a statement. "Further, industry loss warranties in general are making up an increasingly large part of the reinsurance market."

The activity on the three different exchanges is evidence that the market will continue to grow, said Bartell.

"There will be opportunities to arbitrage between the three exchanges, which is good," he said. "Maybe not everyone will be successful, but it gives us a good feeling that we are heading in the right direction."

* The News: Several new types of catastrophe-linked derivatives have been launched.

* The Background: cat futures were first attempted in the 1990s, but never took off.

* The Payoff: The growth of this new market gives insurers another way to balance risk while giving investors a way to take on insurance risk without writing policies.

Contract Types

Derivative: A type of financial instrument, including futures and options, that's priced according to underlying securities, commodities or indices.

Futures: An agreement to buy or sell securities or commodities at a set price at a set time in the future.

Options: An agreement that gives an investor a right, but not an obligation, to call (buy) or put (sell) a certain number of shares Of a specific sock or Commodity at a set price for a limited time.

Learn More

Swiss Re Group

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Distribution: Reinsurance brokers

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