Insurance-Linked Securities Report 2008 - Aon

Continued Innovation
Options and futures evolve, but lack liquidity
Innovation in the financial markets has characterized the growth of economies for
a very long time, and its impact on the banking, investing, and insurance industries
is well documented. Indeed, in just the past several years we have witnessed the
development of various forms of options and futures, new methods of risk transfer,
and customized forms of capital. The demand for further customization, combined
with the competitive forces encouraging intermediaries to meet it, have propelled
market players in the United States, Europe, and Asia to foster new ideas. Thanks
to an improved computational resources and increasing analytical sophistication,
innovation in insurance finance continues to be a work in process. The use of options
and futures contracts in the insurance industry is a prime example.
Historic Perspective
Aon Capital Markets
In 1992, the Chicago Board of Trade (CBOT) introduced the first insurance derivative
contracts, which were based on the experience of 22 insurers. The futures and
options contracts initially focused on various regions of the United States, offering a
new method to manage catastrophic risk. Due to a lack of historical reference data on
these initial contracts, however, risk-takers avoided them. In response, contract terms
were changed to include well-known metrics such as those compiled by the Property
Claims Service (PCS). Concurrent with this change, contracts became available
based on nine regional U.S. indices (National, Eastern, Northeastern, Southeastern,
Midwestern, Western, California, Florida and Texas).
Rising to a high of over nine million contracts in 1997, volume declined to negligible
levels in subsequent years and the CBOT eventually discontinued trading. These
standardized contracts, available in various combinations, offered more trading
flexibility than ever before, but were unable to sustain ongoing popularity.
Three exchange-traded derivative platforms have been created in the past year, and
deserve review. They are the Insurance Futures Exchange, Carvill Hurricane Index,
and Re-Ex.
• The Insurance Futures Exchange (IFEX).
Continuing the evolution of insurance derivatives, IFEX launched Event
Linked Futures (ELF) last year. IFEX created ELFs as contracts for difference
with full payment triggered once losses exceed pre-specified amounts, unlike
reinsurance policies. ELFs more closely resemble industry loss warranties
(ILW) than options. Unlike ILWs, buyers of ELFs do not have to suffer direct
losses to receive a payment once the industry loss strike amount has been
reached. These industry losses are determined by PCS, which is commonly
used to estimate catastrophe losses in support of index cat bonds.
IFEX currently offers 2008 and 2009 ELF US Tropical Wind First and Second
Event contracts. Trigger levels are at $10 billion, $20 billion, $30 billion, $40
billion and $50 billion of industry losses over a calendar-year risk period.
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