Beyond Saffir-Simpson: trading hurricane futures on the CHI-Town Mercantile Exchange.

Steve Smith, president, property solutions, of Carvill America/ReAdvisory developed the Carvill Hurricane Index (CHI), the index used as the basis for trading hurricane futures and options on the Chicago Mercantile Exchange (CME)--an attempt to spread the risk of trading hurricane futures to the broader financial markets.

As of late summer, CHI products on the CME had traded approximately 31,000 contracts with a notional value of close to $60 million--the largest opening series of trades for a new weather commodity product on any exchange. The products have been traded by insurers, reinsurers and hedge funds. The CHI products on the CME allow users of risk to access the broader capital markets in an open, transparent and credit-worthy manner. The CHI itself is crucial to this process as it takes as its inputs publicly available data from the National Hurricane Center.

The CHI is a near real-time measure of the damageability from a hurricane and allows CME to settle, trade and effectively pay claims within three days of a landfall event. Users of the CHI products on the CME therefore get tremendous cash flow benefits as well as the full faith and credit of the largest financial exchange in the world.

The CHI is recognized as a truly breakthrough product. Prior to it entering the market within the past year, the ability to rate a hurricane as it approached landfall was an imperfect science at best. The Saffir-Simpson scale has been widely used for this purpose for over 30 years, yet its structure and lack of complexity were not entirely well suited for use by the insurance industry or the public at large.

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Then along came the CHI, which accounts not only for the maximum sustained wind speed of a hurricane but also the size of the storm. Since the CHI takes as its input readily available data, it is easy to calculate. By comparison, the Saffir-Simpson Scale focuses most on wind speeds and surge potential when classifying a tropical storm.

The inspiration for the CHI came in 2005. "That year we had all these storms and I tried to describe them to the readers of my daily report," recalled Smith. "At some point I realized I was using all these wordy kind of terms. So we decided to do something like the CHI. There was some data out there from the University of Colorado. We took that and we applied it to creating me CHI."

Interest in weather risk management has been growing noticeably, according to the U.S. Department of Commerce, which projects that as much as one-third of all U.S. commerce is directly touched by weather.

John Cavanagh, CEO of Carvill Reinsurance Intermediary, said: "I think a lot of retail interest will be developed like, for example hotels on the coast, anybody with a coastal exposure that has an impact on their business from hurricane risk."

There are three types of contracts: one covers a named storm; one covers the aggregate of the storms in one season; and another covers the largest storm in a season.

Although the CHI was introduced a year ago, there have been major modifications. For example, initially Carvill had five overlapping regions limited to the Atlantic and Gulf coasts in the United States. After awhile they added an important sixth region. That region is called the "eat-in-the-box" region and runs from Galveston, Texas to Mobile, Alabama. The importance of this region, said Smith, "is that it encompasses the majority of the offshore oil rigs."

Another important modification has been to be able to do a deal as a typical derivative or as a reinsurance contract. Being able to offer these contracts as a reinsurance contract has the overriding value of being able to keep the rating agencies happy. This change, notes Smith, will allow reinsurers to take full credit on their financials for a reinsurance transaction. Further, Smith notes that this alternative helps placate regulators, since they rarely give full credit for derivatives.

Smith notes that this single change should make the product much more attractive to reinsurers.

A client of Smith who knows him well said Smith was ideally suited to be the creator of the CHI. "He has a background in atmospheric physics as well as having traded weather derivatives."

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Indeed, Smith earned a doctorate in meteorology from the University of Oxford in the United Kingdom, as well as a M.A. in physics. In addition to working in weather derivatives, he spent a couple of years working at investment banks. "I got a close look at how people trade," he said. And finally, in the past six or seven years he has worked in traditional reinsurance on the property and casualty side.

"So I spend time thinking of how people model portfolios and about how people model risk," he said.

One of Smith's clients spoke highly of Smith's daily report. "His reviews of hurricanes are one of the most well read from a reinsurance standpoint." One of the great features of the CHI, said this client, is that it allows for claims to be settled within days after landfall of a hurricane.

Personally, said this client, Smith is a very down-to-earth, very intelligent person who communicates well.

"Steve is very witty, with wide ranging cultural interests. In business, he does good presentations," said one business associate. "He's a good communicator."