Hurricane futures join CME's suite of weather products
Though it may be great television drama, it doesn't really help insurance companies and other businesses with financial exposure to hurricane damage. But now, heading into the 2007 hurricane season, new products offered by CME – futures and options on the new Carvill Hurricane Index (CHI) – offer a level of protection against severe economic losses.
Size counts
“There is more to a hurricane than just wind speed,” points out Dr. Steven Smith,
developer of the CHI. “The location of the hurricane is important and so is the size
of the storm.”
Smith is an atmospheric physicist and senior vice president of the ReAdvisory America Group of Carvill, a firm founded in 1977 that specializes in property and casualty reinsurance in medical malpractice, errors and omissions, and other areas with highrisk exposure, now extending to hurricane damage. Using publicly available data from the National Hurricane Center (NHC) of the National Weather Service, he devised an index based on both the maximum wind velocity and the radius of the hurricane to calculate the potential for damage from a storm.
In recent years, the intensity of a hurricane has been measured on the Saffir-Simpson scale of strength, the commonly mentioned Richter scale-like reading developed in 1969 that places hurricanes into five categories based on wind speed and the expected storm surge. A shortcoming of that scale is that just a one mile-per-hour change in wind speed can drop a hurricane from Category 3 (winds of 111 to 130 miles per hour) to Category 2 (winds of 96 to 110 miles per hour), implying less potential damage. Hurricane Charley, which crossed over central Florida in 2004, and Katrina, which slammed into New Orleans and the Gulf Coast in 2005, both had wind velocities of 145 miles per hour at one point and were classified as Category 4 storms as they neared land. But they were dramatically different in overall size and the level of damage they caused. These differences were not recognized by the Saffir-Simpson scale because it does not measure the radius of the storm from the eye as it nears land. The average radius for hurricanes is about 60 miles; Charley had a radius of only 30 miles, while Katrina's was 120 miles.
In contrast, the CHI, which does take storm radius into account, was 10.4 for Charley, compared with a CHI of 19.0 for Katrina (after a peak of 27.0 – see graph). Both Rita and Wilma had higher wind speeds than Katrina in 2005, but the combined strength and size of Katrina gave it the highest potential to cause the most damage overall, as reflected by the CHI and what actually occurred. That is important information for insurance companies and other affected businesses to know.
Risk-transferring mechanism
The 2005 hurricane season caused an estimated $79 billion in
damage and strained insurance companies' capacity to provide
insurance to customers. With CME's hurricane futures and
options, these businesses can transfer their risk to the capital
markets, as other businesses do.
CME, which has been trading weather-based products since 1999, started listing three CHI contracts – CME Hurricane Event futures and options; CME Hurricane Seasonal futures and options; and CME Hurricane Seasonal Maximum futures and options – for five geographic regions along the East and Gulf Coasts, stretching from Eastport, Maine, to Brownsville, Texas, on March 12. Customers are more inclined to take an initial position on an entire hurricane season and then take additional positions on a hurricane itself – based on developing hurricane patterns. The CME Hurricane Event contract does not become active until the NHC begins to issue hurricane advisories and posts the information on its Web site so it is transparent to all participants.
The front contract expires when the hurricane makes landfall, with contract settlement based on CHI values provided by Carvill. Each CHI point is worth $1,000, with a minimum tick size of 0.1 point, or $100. The initial margin is $675 for speculators and $500 for hedge funds and members.
Calm before the storm?
There could have been plenty of trading activity during the
hurricane seasons of 2004 (Charley, Frances, Ivan, Jeanne)
and 2005 (Dennis, Katrina, Rita, Wilma). In 2006, however,
only Hurricane Alberta might have spawned a little trading
before fading away. With no hurricanes reaching the U.S.
coast, the CHI contracts would have expired and become
worthless despite forecasts that 2006 would be another
active hurricane season.
“Hurricane forecasts have not been very good historically – no better than looking at the last year,” Smith says, noting there have been at least three forecasts for an active hurricane season in 2007.
Smith expects most of the initial trading in hurricane futures will be related to specific storms as traders add to or top off their coverage against losses from hurricane damage. Eventually, he expects firms will look for coverage for the whole hurricane season with a contract that aggregates CHI points and settles around the first of December.
The benefit of hurricane futures and options extends well beyond the insurance world, he adds, noting that any business or industry that has direct exposure to financial loss from hurricane damage will find them useful. That includes the energy industry, utilities, local governments, insurance and reinsurance companies and even hedge funds. In addition, those concerns with secondary exposure, such as a utility in the Midwest facing higher natural gas costs, will find CME hurricane futures and options an attractive way to hedge against rising costs. All you have to do is look at the effect Katrina had – and continues to have – on energy prices and the U.S. economy.
“You could make the argument that the U.S. economy has more exposure to hurricane risk than it does to any other weather risk,” Smith contends, noting that trading in CME weather products was valued at $22 billion last year. “I forecast that hurricane futures could be bigger than all the other weather markets.”
www.cme.com/cmehurricane