A new market emerges for Mother Nature

WASHINGTON — A new financial product will allow traders to bet on which way the wind blows. The Chicago Mercantile Exchange today began selling hurricane futures contracts and options on futures contracts. “This is an example of the exchange listening to customer needs,” said John Harangody, director of commodity products for the exchange. “Insurers approached us to look at this area of risk so it could be better managed.” After Hurricanes Katrina and Rita caused about $79 billion in damages in 2005, it became clear that insurers have limits on insuring all claims. Hurricane contracts represent one way for insurers to transfer their risk to the capital markets, Mr. Harangody said. For instance, an insurer with $100 million in exposure might usually sell the last $80 million to other firms to take away part of that risk. Using hurricane contracts, insurers can protect themselves and give non-traditional participants a way to put their capital to work in these markets. Other buyers for hurricane contracts could include energy companies with oil-producing platforms in the Gulf of Mexico. Additionally, pension funds, state governments and utilities might use the contracts to hedge their risk of hurricanes. In fact, the U.S. government estimates that about $1 trillion of the American economy is weather sensitive. The Chicago Merc contracts will cover five areas: the Gulf Coast, Florida, the southern Atlantic Coast, the northern Atlantic Coast and the eastern United States. The hurricane season in those areas lasts from June 1 through Nov. 30. London-based Carvill Group, a reinsurance firm, will calculate the underlying index, which will be known as the CME-Carvill Hurricane Index. Using maximum wind velocity and the radius of each hurricane, Carvill will calculate the damage potential of the hurricane, Mr. Harangody said. Once the hurricane hits land, the contract for that area expires, and the transaction will be settled in two business days. Carvill created an index that is easy to calculate and based on publicly verifiable data, said Steve Smith, senior vice president of ReAdvisory, the analytical arm of Carvill. It was a challenge to create an index that can be calculated and settled within hours of an event, but that was most important to the trading community, he said. The market opens with contracts available on Hurricane 1, Hurricane 2 and Hurricane 3 for the year. As these first three storms either make landfall or dissipate, the exchange will list subsequent contracts. Forecasters at Colorado State University in Fort Collins are predicting seven hurricanes for the 2007 season, compared with an average of 5.9 hurricanes between 1950 and 2000. There were 14 hurricanes during 2005 and five last year. As a hurricane gets closer to land, and as more is known about the effect it is expected to have, the price of the contracts is expected to rise or fall along with the worry about its impact, Mr. Harangody said. Firms outside the insurance industry will have to weigh the cost of the contracts against the expense of hurricane insurance, which most firms with exposure to such weather events already have, said Fadel Gheit, an oil and gas analyst at Oppenheimer & Co. Inc. in New York. Hurricane insurance policies typically include a cap on what they will cover from a given storm, so this “could give producers some flexibility” in deciding how much risk to cover with insurance, he said. The hurricane contracts are just one more financial risk-mitigation tool to come out in a long line of new products introduced in the past five years, Mr. Gheit said. “People are running out of things to bet on,” he said. “Now we’re betting on Mother Nature.” Investing in weather is a growing business. The notional value of weather-risk-management contracts between April 2005 and March 2006 increased nearly fivefold to $45.2 billion, from $9.7 billion for the comparable period a year earlier, according to the Weather Risk Management Association in Washington. Trading of weather products on the CME also has undergone a boom since weather derivatives were launched in 1999. Last year, the CME’s weather derivatives had a notional value of $22 billion, according to the exchange. Some say the hurricane contracts aren’t particularly novel and may run into rough seas in the marketplace. “At least two or three carriers have been offering wind derivatives for two years now for operations in the Gulf and onshore within a described radius of defined wind speeds,” said Marshall Nadel, senior vice president of the Aon Natural Resources group, a unit of Chicago-based Aon Corp., which provides risk management services. There haven’t been many takers, because of their expense, he said.