How to weather the storm

Hurricane
Hurricane season is under way. In August, tropical storm Fay has already caused the deaths of 14 people in Haiti, rumbling its way over the Dominican Republic and Florida. Potential catastrophe requires the need to insure yourself against future damage. A year after Katrina hit in 2005, the insurers and the reinsures were arguing not over details, but a USD40 billion difference in damages.

The major problem is how do you give yourself instant fiscal protection, rather than waiting for the flotsam and jetsam to wash away before damages can be assessed, debated, and compensated?

The Carvill Hurricane Index (CHI) is less a method of insurance, than an easy method of hedging risk. The index’s parametric structure encompasses the power of the storm, and the radius of the hurricane force winds. The existing factors for measuring hurricanes are insufficient if you wish to monetarise the results. The existing measurement of hurricanes, the Saffir-Simpson scale, categorises storms as either weak or strong, from a scale of one to five (Katrina for example was a weak 4-strength hurricane). You can’t trade ‘weak’ or ‘strong’, so John Cavanagh, joint CEO of Carvill, employed Dr. Steve Smith, Carvill’s on-staff atmospheric physicist, to develop a formula, the CHI. The CHI combines the Saffir-Simpson scale with two factors of storm power and speed. This allows the CHI to show than hurricane Katrina had a far greater potential for damage that hurricane Wilma, one of the strongest storms on record, as Katrina had a far greater radius.

The index is a volatile as the subject of measurement. The largest storm in 2005 measured 19 on the CHI. The aggregate value of all land falling storms during the same year came to 48 on the index, the sum of Katrina, Wilma and others. In 2006, the aggregate value was zero, as there were no land falling storms. In 2007, it was 1.4, with only Humberto, a hurricane that formed and intensified faster than any other tropical cyclone on record before landfall.

“The reason we created the index, and the reason we want to create a derivatives market, is that there is simply not enough capital to support our catastrophe risk (CAT risk) in the insurance industry,” explains Cavanagh. He uses Florida as an example. If you are unable to receive insurance anywhere in the USA, you can go to a state fund or a state plan, a governmental vehicle through which you can insure. Typically it is the coastal territories that use these vehicles the most. In Florida, many of the major insurance companies have withdrawn from writing coastal business because of hurricane volatility. The tab is now being picked up by the state, under the name of a company called Citizens.

“The demands posed by the rating agencies and capital providers, on assuming CAT risk, are such that it doesn’t make it economically viable, so a lot of the companies have pulled out of underwriting CAT and it has all fallen on the state. This is not very good from an economic point of view”, states Cavanagh. “What we are trying to do is create a deeper more flexible market for CAT risk. What has happened in our industry is that the capital markets are upon us, and we have seen the emergence of catastrophe bonds and event loss swaps and side car deals and a number of hybrid financial market products to package CAT risk, but what we haven’t seen yet is a proper derivatives market, and that’s what we are trying to create here.”

Carvill aims to do this through three contract types, in standard futures and options form and in binary form.

The first contracts are called the ‘named storm contracts’. This essentially means you can various hurricanes; the first of the 2008 season, Hurricane Bertha for example. Whether you are in the money or not depends on the final value when the storm makes landfall. If it doesn’t make landfall the storm has a value of zero.

The other contract – considered to be a buy-and-hold in the insurance industry – is speculating on the largest land falling storm during a season. The third contract is speculating on the aggregate size of the land falling storms during the whole season. This is simply an aggregate stop-loss.

According to Cavanagh: “The largest land falling storm is the most popular because our industry has to hedge against a large, land falling storm every year, so by definition that is the most popular contract. We have traded all the contract specs but the vast majority have been speculating on the largest land falling storm.”

Interestingly, actual hurricane damage is irrelevant from the standpoint of the index. This is due to fears of corrupting the quality of the index. Not having to rely on industry data, population shifts or demographics to adjudicate the size of the storm, allows the index to stay strictly parametric.

Cavanagh’s motivation for build up the CHI was to create more capacity. “We reckon in our business a one-in-a-hundred event could do around USD130-150 billion of damage”, he explains. “If you relay that to the global equities market for example, a 1% drop in the stock market is a USD590 billion, and the market doesn’t even blink, whereas USD130 billion would take our industry out. It gives you the relativity on how markets can absorb volatility. We don’t have enough depth in our market. If you look at any other market, commodities or otherwise, they all have deep derivatives markets. Every time there is a barrel of oil drawn out of the ground it is traded twenty times over in the derivatives market. It’s twenty times the size of the underlying asset. In the credit market it’s forty times, through CDOs and other instruments. This is the industry we are trying to create.”

Cavanagh has also created the ability to trade risk. In the insurance market, there is a buy and hold philosophy. In other words, portfolios of risk are created and protected on an annual basis. Through the CHI there is the ability to trade risk, an option there have never been before in this industry.

At present, the index is restricted to the US, although Cavanagh states that if Carvill can find the territories, then they will expand. Japan has excellent weather data and advisers that efficiently capture data relating to tsunamis or typhoons. Europe on the other hand, produces patchy and inconsistent data due to the number of countries involved, creating a lack of consistency regarding data output. For now Carvill seem focused on expanding the American market.

The major competition comes from two other products. The first is a NYMEX product promoted by Gallagher’s, an insurance brokerage in the USA. This product uses, Property Claims Service data (PCS). This is essentially landfall data; damage data that is captured from a number of different insurance companies in the States, from which you can adjudicate on the size of the event. The major difference from the CHI is that damage is the key factor. In essence, it is a damage index and it has a settlement of three months after the close of the contract. The contracts themselves run for 12 months, then the settlement period is three months following.

However there are significant problems with this index. Katrina again serves as a useful example. Katrina happened in September 2005. The PCS data works by putting out an initial estimate of loss. When they estimate that initially they estimated it at USD21 billion. The 12 months later they revised it to USD41 billion. There is therefore huge basis risk associated with any product that deals with initial estimates PCS.

The other rival is the Insurance Futures Exchange Services (IFEX). This index also uses PCS but instead only use the final estimate PCS, so, like the previous product, these contracts are structured on a twelve month basis, however you have to wait 18 months for the final settlement.

This is where the CHI separates itself from its rivals. Because actual damage is not an issue, according to Cavanagh: “The minute we put out an advisory on the size of the loss it is calculated by the last advisory prior to landfall then in 12 to 24 hours we denominate a value. In 36 hours the money is in the bank. Cash flow wise it is fantastic for our business.” In an age where many companies cannot wait for delayed payment, increased liquidity can only be a bonus. While many conservatives out there may grumble on the increasing expansion of derivatives into new spheres, the CHI allows you not only to hedge risk, but also to expand and diversify your portfolio. It may also be the end of weather as small talk.

Biography
John began his career in 1975 in London with Lloyd’s brokers Alexander Howden & Company, and later joined Willis Faber & Dumas in the North America Reinsurance area in 1977, becoming a divisional director in 1982. During this period he spent a lengthy secondment working with Johnson & Higgins and Wilcox in New York. In 1984, Cavanagh joined J. H. Minet & Co. Ltd as director of the North American Insurance Division, and during 1987, he became deputy managing Director of Minet Re, Ltd. John joined Carvill in 1988 as a director of R. K. Carvill & Co. Ltd, and was appointed Vice chairman of Carvill America, Inc. in 1996. John was appointed chairman of Carvill Re in November 2004 and joint CEO of Carvill in April 2005.