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Futures Markets & Catastrophe Management

This analysis by Robert Eramo, Vice President and Corporate Actuary at CNA Insurance, delves into the genesis and dynamics of catastrophe futures, initiated by Richard Sandor in December 1992. Highlighting his unique perspective gained through personal experience at Johnson & Higgins, Eramo discusses the challenges and potential of a liquid insurance market through CAT futures. Key points include contract structures based on ISO loss ratios, the role of primary participants in hedging, and limitations such as basis risk and liquidity issues. The text also contemplates future prospects for risk transfer in the insurance industry, emphasizing the evolving landscape shaped by technology.

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Futures Markets & Catastrophe Management

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  1. Futures Markets & Catastrophe Management Robert Eramo Vice President & Corporate Actuary, CNA Insurance

  2. Personal Experience • At Broker Johnson & Higgins at the time • On Task Force Recommending J&H Participation • Futures Launched in Dec. 1992

  3. CAT Futures • Created by Richard Sandor, original creator of the Treasury Futures in 1975 • Traded on Chicago Board of Trade (CBOT); Dream of Liquid Insurance Market • Based on an ISO Loss Ratio • Property Losses (Non-Fire) to Property Premiums

  4. Call Option Characteristics • A typical experience quarter may have an expected 10% loss ratio • Contract Quarters had several strike prices • A 10% Strike Contract reimbursed a buyer 15% if loss ratio were 25%

  5. Similar to Aggregate Excess Contract • However Aggregate Excess Pays Specific Losses to Insured • CAT Future Pays Based on Industry Experience • Thus Basis Risk Relative to Actual Experience • More Like Loss Warranty Writings Tied to an Index

  6. Basics Of Viable Futures • Primary Participants Hedge • Secondary Participants Trade/Speculate • Primary Buyer, Cereal Manufacturer Hedges Price of Corn • Primary Seller, Farmer ADM Hedges Price of Corn

  7. Buyer’s Hedging Interest Lacking • Primary Insured and Primary Insurers Want Indemnification for Losses • Original Cat Futures Rarely Provide Indemnification • Selling Interest Sufficient - Similar to Other Insurance Writing

  8. Consequences Part I • Few Contracts Written • Consequent Lack of Liquidity Provided Nil Opportunity for Traders or Speculators • Floor Operations a Money Loser • Contracts Quoted at Prices Often Higher than Aggregate Excess Contracts. Why buy when you were assuming Basis Risk?

  9. Consequences Part II • Actual Buyers Often Marginal Risks Hard Pressed to Find Any Cover • Could Have Appeal to More Insureds in Tight Market • Appeal Would Disappear Under Normal Market Conditions

  10. New Contract Born I • Based on Actual Evaluation of Catastrophic Event as Assessed by Property Claim Services Office • Premium No Longer in Experience • Some Contracts Specifically Concentrated on One Peril • Countywide and Regional Contracts

  11. New Contract Born II • Contract Bought for Loss Amounts XS of an Index. • Index of one was a $10 Billion event. • Contract, however, still has basis risk!

  12. Where From Here? • Is dream of Liquid Insurance Market Gone? • Will Internet Eventually Be Provide the Machinery for the Quick Transfer of Risk? • CATEX May Be Starting Point • Liquid Market May be Limited to Profession Reinsurance Market • Probably Always Limited to Property

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