INSURANCE
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THE SECURITIZATION OF INSURANCE RISK

Insurers and reinsurers typically issue catastrophe bonds through an issuer known as a special purpose vehicle or reinsurer, a specialized company set up specifically for this purpose. The bonds pay high interest rates and diversify an investor's portfolio because natural disasters occur randomly and are not associated with economic factors. Depending on how the bond is structured, if losses reach the threshold specified in the bond offering, the investor may lose all or part of the principal or interest. There is growing interest in securitizing life insurance company portfolios and a catastrophe bond public fund has been launched in Europe for individual investors. Discussions are taking place on securitization of auto insurance and other commodity-type insurance risks.
CATASTROPHE BOND TRANSACTIONS, 2004

($ millions)


Special purpose vehicle

Sponsor

Risk amount

Peril

Risk location
Oak Capital Ltd. Swiss Re$34.5WindstormEurope
Sequoia Capital Ltd. Swiss Re22.5EarthquakeCalifornia
Arbor I Ltd. Swiss Re85.8MultipleU.S., Europe, Japan
Residential Re 2004USAA127.5MultipleU.S.
 USAA100.0NANA
Helix 04 Limited Converium Ltd.100.0MultipleU.S., Europe, Japan
Gi Capital Ltd.Unnamed Japanese insurer (1)125.0EarthquakeJapan
Foundation Re Ltd.Hartford Fire Ins. Co.180.0HurricaneU.S.
 Hartford Fire Ins. Co.67.5MultipleU.S.
Redwood Capital VSwiss Re150.0EarthquakeCalifornia
Redwood Capital VISwiss Re150.0NANA

(1) Sponsored by Swiss Re.

NA=Not available.

Source: Guy Carpenter; MMC Securities Corp.

WEATHER-RELATED HEDGES

Weather-related derivatives and insurance allow such businesses as ski resorts, oil and propane gas distributors, and others that may experience large swings in annual sales due to weather conditions, to hedge their weather-related risk.

Developed initially by an energy company in the late 1990s and now being offered by insurers and reinsurers (the insurers of insurance companies), weather derivatives typically are indexes derived from average temperatures, snowfall or rainfall. Weather derivatives come in the form of options or swaps. A weather option is a trade that pays an agreed amount at a specific time, based on the occurrence of certain weather conditions, such as summer temperatures more than five degrees below average. A weather swap is an exchange of funds between two entities likely to experience different conditions. Money changes hands for every point above or below a certain threshold. Contracts can be tailored to meet specific needs.

Companies can also buy an insurance policy. These policies generally have a dual trigger, one weather-related, such as heating degree days, and the other based on reduced sales or some other economic indicator. These products are treated differently from derivatives in terms of accounting and taxation.

Weather-related hedge products are different from other kinds of weather insurance, such as policies that protect against specific events being cancelled by poor weather, and different from catastrophe bonds, see Securitization of Insurance Risk in this chapter.
GLOBAL WEATHER RISK PRODUCTS,
VALUE AND NUMBER OF CONTRACTS, 1999-2003 (1)



Year

Notional value
 ($ millions)

Number of contracts
1999$3,0031,285
20002,5172,759
20014,3393,397
20024,1884,517
20034,5783,162

(1) Based on companies responding to a survey conducted by PricewaterhouseCoopers for the Weather Risk Management Association; excludes Chicago Mercantile Exchange trades.

Source: PricewaterhouseCoopers.

  • According to a survey by Weather Risk Management Association and PricewaterhouseCoopers, from 2002 to 2003, the number of transactions in the global weather market fell by 30 percent but the value of those transactions increased 9 percent.

PARTICIPANTS IN THE 2003 WEATHER RISK MANAGEMENT ASSOCIATION SURVEY (1)


Participation by main line of business

 

Participation by location of respondent

 
     Banking3     Asia6
     Energy7     Europe5
     Insurance5     North America7
     Other4     Other1
 Total19

(1) Based on companies responding to a survey covering 2003/2004 conducted by PricewaterhouseCoopers for the Weather Risk Management Association; excludes Chicago Mercantile Exchange trades.

Source: PricewaterhouseCoopers.

WEATHER CONTRACTS TRADED AT THE CHICAGO MERCANTILE EXCHANGE, 1999-2004

($ millions)


Year

Notional value

Number of contracts
1999NA336
2000NA59
2001NA131
2002$1914,446
20031,70019,094
2004 (1)62839,000

(1) January-August, 2004.

NA=Data not available.

Source:  Chicago Mercantile Exchange.

  • The Chicago Mercantile Exchange (CME) is a key component of the weather risk management industry. Weather contracts traded on the CME totaled 19,094 in 2003 – more than three times the number traded over the previous year. In the first eight months of 2004, these contracts had doubled from 2003.