Is There A Future In Trading Of Catastrophe Futures?

Which begs the question, why would an investor participate in a market characterized by massive and unpredictable losses?

Unlike most economic indexes, it is generally agreed that random acts of nature have no meaningful correlation with other economic events, whereas cat futures and options are based on that connection. Part of the explanation for the attraction is that a catastrophe future or option provides an investment opportunity for portfolio managers, hedge funds and other sophisticated investors while simultaneously reducing the volatility of a portfolio of financial exposures.

And, as catastrophe models have become increasingly more sophisticated, investors have become more comfortable with measuring this risk.

New catastrophe index futures, launched in February 2007, are structured as one-year contracts, starting and ending on the last day of March. The futures contract will settle against an index known as the Re-Ex index, based on data supplied by Property Claim Service (property damage estimates for a range of natural perils) and posted and revalued on a daily basis when losses observed move by $25 million or more.

The contracts will cover two geographies traditionally impacted by hurricanes, and the country as a whole. As the contract settles against total property losses for the insurance industry, the nationwide index could be impacted by perils other than hurricanes, such as an earthquake in California. The value of the forward contract is valued at the index times $10.

There are also competing tools to take advantage of the perception of high prices. Catastrophe bonds, insurance "sidecars," privately traded industry loss warranties (which have indemnity and index triggers) and a plethora of private placement parametric structures compete directly with the tradable futures contract.

Beyond the hedging and profit aspects, futures and options may provide an efficient way to participate in the risk market without the challenges of forming an insurance company.

On a macro level, an insurance company could use these tools as a substitute form of reinsurance to protect its portfolio.

On a micro level, an offshore oil driller might protect against the expenses of shut-in and lost production at a time when prices typically spike.

In both cases, buyers of either index should be plentiful, as the payoff for being long will offset losses they could incur in their operations.

There are other potential benefits to catastrophe futures, most notably as an indicator of investors' perceptions of weather trends.

Hurricane Katrina created unusual turmoil in the insurance market as insurers were impacted by massive losses and reacted by lowering capacity and increasing rates. Conversely, the following year was unusually quiet for catastrophe loss activity, creating record insurance profits. Unsurprisingly, property owners and politicians began complaining about those profits and demanded that insurance rates decrease.

A catastrophe futures and options trading model could have provided greater transparency on pricing and risk, providing a market-driven price along with additional sources of efficient capacity, and may have headed off the price spikes and subsequent criticism.

The concept of an insurance futures contract allows any investor to synthetically enter the business of insurance when the investor perceives the price to be attractive compared to the risk.

For example, in today's marketplace, a typical buy opportunity would start immediately after a hurricane–when prices rise and capacity decreases as insurers who suffer losses quickly exit the marketplace. Insurers who jump in the market at that time stand to gain an exceptional return.

A properly functioning catastrophe futures market should provide coverage more quickly, even after a catastrophe event, and stabilize the marketplace.

Plus, there's an appeal beyond investors–for insurers and reinsurers–since catastrophe futures could be another tool to manage their risks. Unlike an investor, the incentive for an insurance industry participant to invest is to hedge a loss rather than capture a profit. Insurers are seeking capacity and price improvement on exposures that exist as the result of their business activities.

Traditional insurance risk transfer has been the primary alternative for them, and this tool should be simple to compare. And unlike reinsurance, there is no risk of financial failure of the counterparty.

An insurer could also use catastrophe futures to diversify geographic concentration by taking a long position on the location with concentrated exposure while concurrently selling short where their exposure is low. (Editor's Note: An investor with a long position buys a security with the expectation that the asset will rise in value.)

However, insurers and the insured are going to have multiple challenges using cat futures as an insurance replacement:

o Basis Risk.

There is a likelihood that the futures return may be very different from the loss suffered. The futures contract is based on an index over a broad geographic area that will never replicate the actual loss of the holder of the contract.

o Regulatory Risk.

State insurance commissioners and rating agencies may not allow reinsurance credit for risks reinsured through cat futures, primarily due to the basis risk of the instrument

o Liquidity.

Unless the market becomes very popular, the spreads may be large and counterparties not available, or it may not be possible to efficiently unwind the positions when desired. The challenge will be to attract a balance of buyers and sellers, which has been a challenge historically.

o Accounting.

Unlike insurance, where the premium is an expense, the cat futures contract is accounted for as a derivative investment, with all the implications mark-to-market accounting rules of FASB 133 (the Financial Accounting Standards Board's rule titled, "Accounting for Derivative Instruments and Hedging Activities).

The biggest question that catastrophe futures and options must address is why will they work this time? The idea of trading these instruments has been tried, and failed.

The key to success now may have less to do with structure than the changes in the potential participants in the marketplace. Today's hedge funds have become interested in cat bonds and other index structures as they search for excess returns. Interest in catastrophes is growing, even downstream to more traditional investment vehicles, as investors chase alternative sources of return. This trend indicates that trading catastrophe futures is an increasingly attractive investment opportunity.

Nor does the prospect of a long-term investment–up to decades–deter the modern investor. Because of new trading tools, they can bet on the outcomes of the property insurance industry by geographic region, even as a hurricane is approaching landfall.

The promise of another way of managing the exposures is appealing for those who need efficient protection. And the possibility of a new investment class may be equally interesting to investors.

Hurricane Katrina resulted in an unprecedented wave of creativity in the financial and insurance markets to take advantage of the supply-demand imbalance, resulting in rapidly increasing supply and lowered costs.

While trading in catastrophe futures with adequate volume may be an uphill battle, if it does garner the needed volume, it could be another tool to improve the ways we manage one of the most difficult risks of modern society.