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By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®

That seems to be the message coming out of the Chicago Mercantile Exchange, where hurricane futures trading began in 2007, as well as from the European Climate Exchange, where hurricane futures are also traded.

"This thing is starting to look real," said Neil Eckert, CEO of the European Climate Exchange, during a session at the 5th Annual Insurance Linked Securities Summit in New York at the end of January.

But to check to see if this message approximates fact, we must investigate whether the big buyers in such a market--insurers and reinsurers--are actually playing. As Eckert himself admitted under cross-examination from his audience, getting momentum on such a market is like the age-old question of the chicken and the egg. Large (re)insurers have told him they want to wait on the market until trading traffic picks up, but volume won't increase until these buyers plunge into the market.

"We're slowly turning the corner on that," said Felix Carabello in an interview with Risk & Insurance®. Carabello is director of alternative investments at the CME and has experienced the chicken-and-egg issue when he was introducing past innovative markets, like weather products.

So he knows that for these markets to take off, "The chickens have to get together."

It appears it would behoove (re)insurers to get together. According to Eckert's calculations, insurers are tapping into only about 5 percent of capacity available in the capital markets.

The current situation does not appear tenable. Just check out the Jan. 27 announcement by State Farm that it was no longer writing property coverage in Florida.

"What that told us," Carabello said, "is the traditional insurance business model, of aggregating and warehousing risk, that is a model that is potentially running its course."

After all, he said, in the current way most insurers do things with concentrating and transferring risk, they can only sustain a certain number of hits during the year.

Pulling out of Florida is State Farm's way of showing it understands this fact all too well. Activity at the CME in 2009 is an indication as well, according to Carabello. Since trading began Jan. 5, the market's seen more than 3,000 trades, on pace to beat last year's volume of 32,600 (when the market opened in June).

"They're sort of realizing that the status quo is not a model that will be sustainable," said Carabello about (re)insurers. "Our products are not designed to put them out of business. Our products are designed to help them stay in business."

Take the word of Kendall Johnson, a Stamford, Conn.-based managing director of Tradition Financial Services, a top energy broker, and Tradition Re, a reinsurance intermediary.

"The CHI (hurricane futures market) is being used by insurance companies and reinsurance companies because it is being viewed as a viable way to reinsure their portfolio," he said. "Reinsurance companies are not finding the capacity at the levels they regularly find it in the reinsurance market."

Both Carabello and Johnson declined to name specific insurers that have taken part in the hurricane futures market for client confidentiality reasons, with Johnson saying that trade counterparties don't even know the specific buyer they're dealing with.

Johnson did add, "They would be insurance companies that you would have heard of."

INVESTORS WIN TOO

For investors from the capital markets, selling hurricane futures is a way to diversify and get a piece of weather and insurance. Typically, they shy away from the insurance space because of the indemnity nature of insurance contracts.

Hurricane futures, on the other hand, are based on parametric indices and the location of landfall. In the case of the CME, they use the Carvill Hurricane Index based on the size and strength of a hurricane at landfall. Buyers enter into a contract with the seller based on where they think a hurricane could hit them, at what CHI level at landfall. Pay out occurs two days later after landfall (if landfall occurs), said Carabello.

Currently, the CME offers event-based and seasonal contracts and new, second event seasonal contracts. The European Climate Exchange offers trades for first events, second events and on a regional basis.

February 9, 2009

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