Catastrophe Futures: A Better Hedge for Insurers

Abstract

Roll, Richard, 1984, Orange Juice and Weather, American Economic Review, 74(5): 861-880. Rosenthal, Leslie, 1991a, CBOT's Insurance Futures Open Up Huge Risk-Management Opportunities, Financial Exchange, 10(1): 3-5. Rosenthal, Leslie, 1991b, Insurance Futures, Contingencies, 3(1): 26-28, 48. Rosenthal, Leslie, 1991c, New CBOT Futures Contracts Developed to Help Hedge Insurance Risk, Health Insurance Futures Report, In June 1990, the Chicago Board of Trade (CBOT) submitted for approval with the Commodity Futures Trading Commission two insurance futures contracts, one based on health insurance and one on automobile collision coverage. The proposed contracts would be based on the ratio of paid losses to written premium on policies written in a particular month. Under this proposal, information on a sample of policies would be collected from a group of insurers and disseminated regularly so futures traders could develop expectations of the ultimate settlement value. The final cash settlement on the futures would be based on the figures reported by the insurers as of four months after the policies had expired. In February 1991, the CBOT set a target date of October 1, 1991, to begin trading health insurance futures. However, in September 1991, the CBOT announced a delay in the commencement of trading insurance futures. In January 1992, the CBOT announced that trading would commence in September 1992 on a homeowners insurance futures contract based on data collected by the Insurance Services Office (ISO). In August, 1992, the CBOT announced that trading on the homeowners insurance future, the health insurance future and a catastrophe future modeled on the one proposed in this paper would begin trading early in 1993. This article describes the homeowners, health and auto insurance futures contracts proposed by the CBOT, discusses the possible benefits of a functional insurance futures market, analyzes the problems inherent in the initially proposed contracts, and explains why our alternative contract, based on insured losses from catastrophes, avoids many of the problems that affect the other CBOT insurance futures contracts. Futures and the CBOT Futures contracts are an institutionalized form of forward trading. Forward trading is simply the commitment of two parties to engage in the purchase and sale of a good or another financial transaction at a stated future date. Forward contracting, particularly in agricultural commodities, can be traced back to the Roman empire and classical Greece. Trading in futures developed in the 1860s, initiated by the Chicago Board of Trade. The distinction between futures and forward contracts is based principally on four attributes of futures. First, futures are traded only on an organized exchange; twelve futures exchanges are active in the United States alone. Second, futures contracts are standardized as to the quality of the item to be delivered as well as the date and location of delivery. Next, a clearinghouse is involved in every futures trade, and the commitment of each party to the trade is to the clearinghouse. The clearinghouse thus guarantees performance of the future transaction, reducing (eliminating, as claimed by futures exchanges) default risk. Finally, the major difference between futures and forward contracts is that each day futures contracts are marked to market. Any changes in the value of a position are reflected in the accounts of the traders at the end of every trading day. Futures contracts are now traded on a variety of goods, including the agricultural commodities that gave rise to this type of trading, metals, petroleum, interest-bearing assets, foreign currencies, and financial indices. Futures on financial indices, such as the Standard and Poor's 500 index, unlike more traditional futures contracts, cannot be fulfilled by physical delivery of the underlying commodity at expiration; instead each trader's position is closed out by a reversing trade (e. …