Wall Street Prepares For Hurricane Season

This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

The New York Sun

Most of us prepare for hurricane season by stocking up on extra flashlight batteries. Hedge fund traders have a different approach. Some are setting up complex trades designed to profit from the seasonal blight. One approach is to balance purchases of catastrophe bonds, which are a bet on a benign storm season, against holdings of energy futures, which will almost certainly rally if the Gulf Coast energy infrastructure looks threatened.

This is the latest wrinkle in the ongoing quest to fool Mother Nature. The use of weather derivatives — which allow companies to bet on temperature trends — and catastrophe bonds — instruments developed to help securitize the risk of major storm damage for insurers — continues to grow. Not surprisingly, hedge funds have become major payers in both fields, attracted by relatively thin and inefficient markets and a lack of correlation with other asset classes.

Weather derivatives got their start in the late 1990s when Koch Energy and Enron agreed to a swap based on heating degree days. In effect, they agreed to hedge their risk of abnormal energy demand stemming from unusual temperature patterns. With deregulation, utilities grew more concerned about the impact a sudden cold spell could have on natural gas prices and became more aggressive in protecting their profit margins.

Since that time, the business has grown rapidly. In 2000, according to a spokesman at the Chicago Mercantile Exchange, there were 87 contracts traded; last year there were 867,384. These days the CME trades contracts around the weather patterns of 28 cities (18 in America, 10 overseas) as well as a frost contract for Amsterdam and snowfall contracts for Boston and New York.

The director of commercial products at the CME, John Harangody, suggests that the weather business would be even more robust but for a learning curve issue. “It’s easy enough to connect weather and energy for a utility” according to Mr. Harangody. “For other businesses, the link-up isn’t as simple.”

One connection that is straightforward is between hurricanes and insurance losses. Unhappily, there is no hurricane index today, though Mr. Harangody says the CME is considering developing one. In the meantime, last year’s dreadful hurricane season, with losses totaling nearly $53 billion, led to a wide-ranging reappraisal of the industry’s risk profile. It also ushered in rising demand for catastrophe bonds and a related type of security called a sidecar.

Cat bonds are high yield instruments that pass to the investor the abnormal risks associated with a weather catastrophe. (They are also sometimes used to defray risks from other sources, such as pandemics.) They came into being after Hurricane Andrew in 1992. Cat bonds are, in effect, a risk management tool for insurers, and are viewed as an alternative to reinsurance.

Payouts of these bonds are triggered in three different ways: according to losses sustained by a company’s actual portfolio (indemnity bonds), an industrywide loss amount or the loss incurred in a model portfolio.The duration of the instruments is typically one to three years, while reinsurance contracts are normally for only one year. Sidecars, which are newer but gaining in popularity, are similar except that they employ a quota share structure, according to Pano Karambelas of Moody’s. Under these terms, investors (primarily private equity shops) share premiums and also losses with the issuer. They are basically special-purpose reinsurers.

While only $633 million in cat bonds were issued in 1997, the 2005 total was just under $2 billion. An almost equivalent amount had already been raised by June this year. At that time, the total amount of cat bonds outstanding was estimated at $10.4 billion. Sidecar issuance is rising fast, as well, but the totals still lag cat bonds.

A steep rise in reinsurance rates and new assumptions about probable losses have caused a surge in demand for both types of instruments. Steve Ader, an expert on insurance company ratings for Standard & Poor’s, says “the lesson from last season was that the risk of catastrophe was worse than we thought.”

He explains that a hike in reinsurance rates attracted a number of new, small companies. Unwilling to rely totally on these start-ups, many insurers turned to issuing cat bonds, paying large premiums to defray risk, but comfortable in the knowledge that the capital would be there if needed.

Cat bonds may account for only about 1% of total insurance industry capital, according to Barney Schauble, who manages investments in insurance-linked securities for a Bermuda-based hedge fund called Nephila. However, he is certain the sector will grow. He too cites the lack of adequate reinsurance capacity available in the aftermath of the 2005 season.

Why would institutions buy these bonds? Many investors think the risk/reward profile attractive. The premiums are normally between 7% and 8% above treasuries, and the risk triggers are high — based usually on 1-in-100 or 1-in-250 year events.

Standard & Poor’s, in a memo written in March, claimed that no cat bonds rated by that agency had been triggered, astonishing considering the losses last year. One bond, the $190 million KAMP RE 2005 Ltd., was described as being in danger of doing so.

As with weather derivatives, there is a limit to the advantage that one investor may have over another. The firms that project long-term trends only have about 100 years’ historic data to work with. As Mr. Schauble points out, forecasts are imperfect. Improved technology may falsely report increased storm activity, for instance, while really it is simply more accurately detected.

Does global warming mean that hurricane damage will inexorably rise with the heating up of the oceans? Are insurers facing ever-greater risks? No one knows for certain. As Mr. Ader modestly admits, “We don’t fully understand the weather.” Some however, intend to profit from it.

The New York Sun

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