Insurance-Linked Securities Report 2008 - Aon

Insurance-Linked Securities 2008
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There is presently a lack of liquidity across this array of contracts. To date,
trading has been limited to the $10 billion and $20 billion contracts and,
even for those contracts, volume has been light. Only 1,104 of the $10
billion 2008 contracts changed hands from its inception in September
through December 2007. From January through June 30, 2008, only 354
contracts changed hands. IFEX plans to offer other geographies including
Europe and Japan, as well as U.S. catastrophe sub-zones. In fact, contracts
dealing with Florida tropical wind and Gulf Coast tropical wind are currently
under review by the Commodities Futures Trading Commission (CFTC).
IFEX has also created an infrastructure for trading the contracts. All contracts
trade and clear through the Chicago Climate Futures Exchange (CCFE) with
variable margin requirements set by the exchange based on an estimated
daily risk of loss as determined by an outside consultant. The CCFE is
regulated by the CFTC and the National Futures Association.
A simple way to review the economics of these instruments is to compare
prices for ILWs to those of the comparable IFEX contracts. The differences in
indicative prices as of June 30, 2008 demonstrate a potential for arbitrage
between the exchange-traded contracts and the negotiated ILW market.
The accompanying table compares these prices as percentage rates-on-line.
COMPARATIVE PRICING FOR NORTH AMERICAN RISKS (as of June 30, 2008)
Trigger ILW 1st 2008 Event IFEX 1st 2009 Event IFEX
$10 B N/A 36.85% 37.20%
$20 B 27.50% 26.00% 23.80%
$30 B 18.50% 16.80% 15.55%
$40 B 14.00% 12.90% 11.90%
$50 B 12.00% 10.30% 8.90%
Pricing differences between ILW and IFEX contracts can be attributed to
structural differences between the instruments, the bespoke nature of
ILWs, collateralization, transaction costs, currently low liquidity, and the
comparatively short operating history of IFEX itself. A trader’s view of
these risks would determine the potential profit from an arbitrage trade.
Similarly, an insurer seeking to hedge a particular exposure would need
to weigh the relative risks (including basis risk) with the lower cost of IFEX
futures to determine its applicability and attractiveness.
• Carvill Hurricane Index (CHI).
In addition to ELFs, the market has witnessed the development of CHI,
a numerical measure of the potential for damage from a hurricane and
is based on Carvill’s Hurricane Damage Potential Index. In addition
to incorporating the Saffi-Simpson Hurricane Scale, CHI incorporates
additional factors such as sustained wind speed and the radius of hurricane
force winds. It is a continuous measurement, rather than a discrete scale,
starting from zero and having no maximum value.