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Catastrophe derivatives: insuring the insurer against catastrophic losses.

For the first time ever, major property/casualty underwriters have the tolls to manage and control their underwriting exposure to the vagaries of natural and man-made catastrophes. Insurers can effectively insure themselves by quickly and inexpensively freezing their projected catastrophic loss ratios regardless of the magnitude and frequency of subsequent actual catastrophes. The innovation behind this new trend is catastrophe insurance futures and options (a form of financial hedging instruments known as derivatives), introduced by the Chicago Board of Trade (CBOT) in December 1992.

It is axiomatic to say that catsstrophes represent a dangerous risk for property/casualty underwriters. According to the Property Claim Services (PCS) of the American Insurance Association, the United States averages 34 catastrophes (fortuitous events resulting in excess of $5 million in insured property damages and having an effect upon a large number of insurers and insureds) per year. From 1979 to 1991, the PCS identified 448 U.S. catastrophes that caused $29.7 billion in insured property losses. Some of these catastrophes were exceedingly costly to the insurance industry, particularly Hurricane Andrew - which alone, according to current estimates, caused direct insured damages in excess of $15 billion. Since this entire industry has only $130 billion in capital, several major catastrophes occurring over a relatively short period of time could prove to be seriously crippling. At the least, such an occurrence could make property insurance unaffordable for a great many people who need such coverage.

Traditionally, insurers have protected themselves against worst-case scenarios by utilizing a hedging technique known as reinsurance. Whenever a primary insurer feels that it has too much underwriting risk (e.g., it might feel that its insurance reserves are too low relative to the particular policies it has written), it can "cede" or pass on some of this risk to reinsurers. Reinsurance agreements can be either pro-rata or excess-of-loss. With the former, the ceding company gives a portion of its premium income to a reinsurer, and the reinsurer agrees to pay roughly the same portion of the ceding company's losses. With the latter, the reinsurer (in exchange for a flat premium from the ceding company) agrees to pay all losses incurred by the ceding company in excess of a certain amount.

But now insurers have another hedging alternative. Catastrophe insurance futures and options trade daily, and homeowners and health care derivatives are scheduled for introduction sometime during calendar year 1993. Catastrophe insurance futures, or "catastrophe futures," are futures contracts that allow property/casualty underwriters to hedge against unexpected underwriting losses incurred as a result of a major catastrophe or a spate of lesser catastrophes. The price of the contract is based upon an index prepared by the Insurance Services Office (ISO). The ISO index is the dollar loss on $25,000 of catastrophe premiums from a representative national pool of catastrophe policies. Fro example, if this pool incurred $20,000 of losses on $25,000 of premium income for a given quarter (i.e., the quarter's loss ratio was 80 percent), then the index would have a value of $20,000 (before being adjusted for reporting lags, which will be discussed later).

Contracts priced on this index have staggered delivery months of March, June, September and December. A contract represents the previous quarter's losses as reported through the end of the contract month. For example, the June contract price will be based upon losses incurred from January 1 to March 31 as reported from January 1 through June 30.

After the close of each contract month, ISO collects all necessary data from the participating companies composing the pools, and thereafter announces a "settlement price" for the index, which reflects actual losses per $25,000 of premium income. For example, after June 30, ISO collects all necessary information and thereafter reports the actual losses per $25,000 of pool premium for the first quarter, as reported through the end of the second quarter. Prior to June 30, underwriters can trade this contract.

Trading Insurance Futures

Underwriters and others that make up the market for these contracts will form expectations regarding the actual loss ratios on future quarters. For example, when the June 1993 contract was first introduced in December of 1992, the market formed some sort of expectation as to what the catastrophic loss ratio would be for the first quarter of 1993. If this loss ratio were 80 percent (and again, ignoring reporting lags), then the contract would trade at $20,000.

However, if any factors (such as weather or geological predictions, increased seismic activities, etc.) caused expected losses to increase, then the contract price would increase accordingly. For example, if people expected the first quarter's loss ratio to increase from 80 percent to 85 percent, then the contract price would increase from $20,000 to $21,000. This is so because hedgers are actually entering contracts to buy the cash value of the settlement price of the index. Hence, if hedgers expected to receive $20,000 in cash from buying the June index, then $20,000 is what they'll pay for the contract to buy this index. If they suddenly think that buyers of the June index will receive $21,250 in cash, then they'll be willing to pay $21,250 for the June contract, and so on

Establishing a Hedge

Suppose that in January, the ABC Insurance Co. forecasted a 7 percent catastrophic loss ratio on $10 million of premium income for the third quarter. The company is located on the eastern seaboard of Florida an would like to freeze this projected loss ratio if at all possible. Simultaneously, the pool manager for the CBOT has forecasted a loss ratio of 6 percent on its third quarter pool premium of $3 billion, with a 75 percent ratio of reported losses to actually incurred losses as of December 31. (This 75 percent ratio accounts for the reporting lag that was previously ignored.)

For the sake of this example, assume that ABC's actuaries share the same expectations as the CBOT's actuaries, in which case the July contract will trade at $1,250, which is the portion of the third quarter's $25,000 premium lost by December 31 - [$25,000 x (forecasted third quarter incurred losses for the ISO pool/the pool's estimated premiums) x % of losses reported by December 31] or [$25,000 x ($200 million/$3 billion) x. 75]. Of course, the contract price will change constantly thereafter as the market's expectations regarding third quarter catastrophes constantly change.

If the company wants to protect all $10 million of its premium income for the third quarter, then it would buy an equivalent amount of premium income in the futures market, as adjusted again for the fact that not all of the losses incurred in the third quarter will be reported by December 31. Thus, the company buy (or "goes long" on) 533 December contracts - approximately equal to [($10 million/ $25,000)/.75], [i.e., (ABC's earned premium/ contract size/A% of losses)]; or more specifically, the company would buy 533 Eastern catastrophe contracts. (In addition to a national catastrophe contracts. the CBOT also offers regional catastrophe contracts designed for specific regions of the country.)

Lifting the Hedge

Now suppose that the eastern seaboard of Florida was in fact severely hammered by hurricanes to an unexpected degree in the third quarter, causing the actual loss ratios for the company and the CBOT pool to be 10 percent and 9 percent, respectively. The ABC Co. thus experiences an additional $300,000 in actual third quarter losses over and above what it had expected in January - $300,000 = [(.10 - .07) x $10 million] or [(ABC's actual loss ratio) x ABC's original expected floss ratio) x ABC's earned premium]. Simultaneously, the CBOT pool experiences an additional $90 million [(.09 - .06) x $3 billion] in unexpected third quarter losses over and above its projected $200 million loss.

Sometime after December 31, ISO will calculate the settlement price of the December contract, which will be $1,812.50, [i.e., $25,000 x ($290 million x .75 / $3 billion)] or [$25,000 x (total reported losses/total estimated premium)]. When the ABC Insurance Co. lifts its hedge by entering 533 contracts to sell the December index, it will experience a futures gain of $299,812.50, [i.e., 533 x (1,812.50 - $1,250)].

Thus, ABC's futures gain of $299,812.50 almost exactly offsets its unexpected underwriting loss of $300,000. In fact, with a properly designed hedge, futures gains will always offset unexpected underwriting losses to a very close degree. On the other hand, should actual losses for a quarter prove to be less than originally expected, the unexpected underwriting gains would offset the futures losses.

In other words, property/casualty underwriters can effectively freeze their loss ratios in advance. Needless to say, the ability to freeze catastrophic loss ratios (regardless of the severity and number of subsequent actual catastrophes!) is an innovation of no small magnitude for the insurance industry. Although catastrophe futures are being described here, catastrophe options (which are actually futures options) work in virtually the same manner, with the difference being that options holders have the right, but not the obligation, to buy or sell catastrophe futures contracts at a certain price within a specified period.

Any major brokerage firm, or any commodities trading advisor specializing in hedging, can design and implement an effective hedging program using catastrophe futures or options. Brokerage commission fees (which include design costs) range between $15 and $30 per "round-trip" contract, depending upon volume, established customer relationship, etc. Thus, in the example discussed above (assuming a brokerage fee of $20 per contract), 533 contracts would have cost the underwriter $10,660 - a small price to pay to freeze loss ratios and thereby avoid hundreds of thousands of dollars in unexpected losses.

Insurance Derivatives vs. Reinsurance

Although insurance derivatives represent a giant hedging step forward for insurance companies, reinsurance nevertheless maintains some distinct advantages (and disadvantages) for underwriters. By utilizing the traditional technique of reinsurance, primary insurers are able to tailor their risk protection exactly as they want, since the reinsurance is designed expressly for their underwriting portfolios. Moreover, reinsurers typically provide consulting advice to ceding companies. On the negative side, reinsurance contract negotiations are lengthy, costly and , once entered into, take away flexibility from the ceding company, which is "locked-in" to the agreement for the duration of the contract.

Insurance derivatives are a much faster, more flexible and less costly means of hedging for primary insurers. On the negative side, hedging with insurance derivatives - which represent a national pool of typical policies - cannot be tailored exactly to the particular situation of an individual ceding company. However, the CBOT policy does almost exactly match the policy pool of major underwriters, since both pools represent a diverse, national insurance base.

Unfortunately, underwriters have not historically used the futures market very extensively. For some, the Chicago futures market still has the reputation of being a crapshoot, and conservative entities such as insurance companies have traditionally shied away from such arenas. However, futures are a legal, valid and powerful hedging device already used extensively by banks, thrifts, pension funds, and many other conservative institutions, and the insurance industry will sooner or later jump on the bandwagon.

Meanwhile, Chicago has the serious educational chore of convincing a traditionally conservative industry that the futures market has finally developed a powerful yet conservative hedging technique especially designed for underwriters. For an industry recently battered by the greatest natural catastrophe ever suffered in the United States, such an innovation is welcome news, indeed.
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Author:Ray, Russ
Publication:Risk Management
Date:Oct 1, 1993
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