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Chicago exchange to trade storm futures

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Chicago exchange to trade storm futures

CHICAGO—The Chicago Mercantile Exchange Inc.'s plans, announced last week, to begin trading hurricane futures and options contracts in cooperation with London-based reinsurance broker Carvill Group will provide welcome additional catastrophe capacity, say observers.

The CME's efforts, along with a similar initiative announced late last year by The New York Mercantile Exchange and London-based Gallagher Re, are likely to be more successful than efforts in this area in the past, in large part because of the reinsurance market's greater sophistication, observers say.

The CME trading is expected to begin March 12. The Carvill Hurricane Index, upon which the contracts are based, uses the maximum wind velocity and radius of each official storm to calculate the potential for storm damage, based on publicly available data from the Miami-based National Hurricane Center of the National Oceanic and Atmospheric Administration.

The NYMEX property damage risk futures and options contracts, which are scheduled to begin trading March 5, are based on property losses from catastrophes, as reported by the Property Claims Services unit of the Jersey City, N.J.-based Insurance Services Offices Inc.

Observers say because the NYMEX data will be traded and cleared electronically through the CME's Globex electronic trading platform, in addition to NYMEX's platform, there may be an opportunity for arbitrage between the two.

Officials associated with both the CME and NYMEX products say volume is difficult to predict, and the market for both products may take some time to develop, although they anticipate it will ultimately be successful. "It's hard to say at this point what the takeup rate will be," said Steve Smith, senior vp of Carvill unit ReAdvisory in Chicago.

"There's an incredible amount of interest, but of course new derivative products do take time to start trading," said Larry Tucker, London-based managing partner at Gallagher Re, which is a division of Itasca, Ill.-based Arthur J. Gallagher & Co. "It's an education process."

Observers say there will be no shortage of buyers for catastrophe risk futures. "We have enough of the right counterparties that understand right away how to use these products, and many of these companies are already trading our weather products," said Felix Carabello, CME director of alternative investment products.

John L. Ward, chief executive officer of Cincinnati-based Cincinnatus Partners L.L.C., an advisory firm that specializes in the insurance industry, said investors indicated their willingness to invest in hurricane risk after the 2005 hurricane season. "I think there probably is an investor interest in participating in transactions like this," he said.

The capacity both the CME and NYMEX products will provide is welcome, say observers and participants. Estimates of the property catastrophe's capacity shortage range from $40 billion to $80 billion, despite last year's mild cat year, said Mr. Smith.

Mr. Carabello said both reinsurers and insurers have expressed interest in the product because "there is a lack of instruments to allow for very dynamic trading right now. You can transact (industry loss warranties) on a bilateral basis, but that type of trading is fairly capital intensive." And on the investor side, this product allows for lower barriers to entry, he said.

"This will help to fill a void in the supply and demand imbalance" for catastrophe risk, Mr. Ward said. "I think they're important new developments in the expanded role of the capital markets. He said that this market has been evolving for the past several years, with cat bonds and other mechanisms. This is "one new tool available to take some of those capital market tools to the next level," he said.

Barney Schauble, a principal with Bermuda-based Nephila Capital Ltd., a hedge fund manager that has invested in insurance-linked securities, catastrophe bonds, insurance swaps and weather derivatives as well as reinsurers, said, "It's encouraging to see people like Gallagher and Carvill and others trying to come up with new and innovative ways to trade this risk. This could be an interesting development."

As to "how much we would use it, and whether we use it, we would have to see what the ultimate product format is like and what the interest is," he said.

"I think it's something that the industry ought to welcome," said Morton N. Lane, president of Lane Financial L.L.C., an independent reinsurance consultant in Wilmette, Ill.

Observers and participants say the CME and NYMEX products are likely to be more successful than comparable efforts in the past, including the catastrophe options traded on the Chicago Board of Trade in the 1990s.

Among other reasons the CBOT options may have been unsuccessful is cat modeling did not exist then, said Mr. Turner, who suggested CBOT may have been ahead of its time. There is a far greater amount of sophistication in the reinsurance market today, which has since embraced both catastrophe bonds and sidecars, he said.

"The market's a little better developed than the last time this was attempted," said Mr. Ward.