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Joe,
Thanks. Vince Joseph Hrgovcic 04/05/2000 04:06 PM To: Vince J Kaminski/HOU/ECT@ECT cc: vkaminski@aol.com, Shirley Crenshaw/HOU/ECT@ECT Subject: CME and CATEX ---------------------- Forwarded by Joseph Hrgovcic/HOU/ECT on 04/05/2000 04:06 PM --------------------------- Lucy Ortiz 04/05/2000 04:02 PM To: Joseph Hrgovcic/HOU/ECT@ECT cc: Subject: CME and CATEX Spotlight Report Exchange products seeing slow trading GAVIN SOUTER 03/20/2000 Business Insurance Page 3 Copyright (C) 2000 Crain Communications, Inc. All rights reserved. Exchange-based insurance products developed in recent years have been somewhat slow to get off the ground. Although several exchanges have offered derivative contracts since the mid-1990s to cover insurance risks, none so far has posted a significant volume of trades. Few insurers, reinsurers or policyholders have been drawn away from the traditional insurance markets, where capacity remains abundant and relatively cheap. As long as those traditional markets manage to weather major natural catastrophes, the allure of the exchange-based products will remain limited, observers say. Also stifling the growth of the exchange-based contracts is the limited number of contracts available, one expert noted. Dealers, he said, are unable to secure a suitable hedge by laying off one contract against another. Although the various exchanges have had a good opportunity to establish a widely used set of new risk financing products, that has not been achieved, said Morton Lane, senior managing director, capital markets division at Gerling Global Financial Products in New York. The main problem with the existing exchanges is that they do not offer a sufficiently diverse array of products, he said. The only way to control the risks in the catastrophe options is to have a diversified portfolio of other contracts, and none of the exchanges currently offers a sufficiently broad range of options to provide for that hedge, he said. Florida windstorm options, for example, cannot be bought and then hedged in the same way that International Business Machines Corp. stock options contracts can be hedged with IBM stock, Mr. Lane explained. The exchanges might be more attractive to investors if, in addition to natural catastrophe options, they included options on other risks, he said. Those might include, for example, satellite, aviation and crop indexes, Mr. Lane said. "For the insurance buyer, such exchange instruments would not represent the perfect risk transfer vehicle, but as long as they are quantifiable and indexable, they may represent a good surrogate," he said. The exchanges could also be used to create a derivatives market for over-the-counter securitized deals, if there are regular issuers of catastrophe bonds, Mr. Lane said. The soft insurance market has also hindered the growth of exchange-based insurance products, said Sean F. Mooney, senior vp and chief economist at Guy Carpenter & Co., the reinsurance brokerage unit of Marsh Inc. in New York. "The traditional market has been so competitive that people are not looking for other ways of doing business," he said. At least in concept, the exchange-based deals are generally similar to the mortgage-backed securities that have been a huge success since they were introduced in the 1970s. "There is a belief that alternative means of transferring risks will grow, but it is difficult to predict when," Mr. Mooney said. Currently, the trading that is taking place typically involves established insurers and reinsurers, so the exchanges have not brought substantial new capacity to the marketplace, he said. Guy Carpenter provided the index for the Bermuda Commodities Exchange reinsurance products. The BCE did not take off, however, and was suspended last year after two years of little activity. The oldest of the insurance-related, exchange-based derivative products are the catastrophe options traded on the Chicago Board of Trade, which began trading the options in 1996. Initially, there was substantial interest in the options, but the soft traditional market has hampered use of the contracts to hedge catastrophe exposures, said Carlton Purty, an independent broker at the CBOT who trades in options. No catastrophe option trades have been completed at the CBOT so far this year, he said. Last year, there was increased interest in the contracts because of Hurricane Floyd, but few contracts were traded, Mr. Purty said. "I think a major, major catastrophe will have to happen before they really take off," he said. The contracts offer real protection, and options dealers are keen to trade in a new niche, but the conventional insurance and reinsurance markets are so soft that few companies are turning to alternative coverage options, Mr. Purty said. The Catastrophe Risk Exchange, located in Princeton, N.J., has radically changed its structure since it was originally announced in mid-1996, and it is well positioned to expand, said Frank Sweeney, chief operating officer. CATEX initially planned to be a computer-based facility for reinsurers that would enable them to exchange catastrophe risks and to build balanced portfolios. But by the time the exchange was operational in November 1996, it was clear that most reinsurers and insurers interested in CATEX wanted only to buy and sell conventional reinsurance, Mr. Sweeney said. Although there was some interest in risk swapping, only a handful of risks were posted on the system, and none was traded, Mr. Sweeney said. Consequently, CATEX has become chiefly a "cash for cover" exchange, he said, noting that the risks reinsured on the exchange include property catastrophe coverage, aviation and liability coverages. CATEX also trades industry loss warranties, where coverage is triggered by an actual loss combined with an industry loss over an agreed threshold. Other adjustments to the exchange included making it accessible through the Internet in November 1998. And late last year, CATEX offered users the ability to set up smaller networks, allowing them form groups whose members do business only with one another. Since its inception, CATEX has completed about 450 trades, totaling $400 million in premium and more than $3 billion in limits, he said. CATEX's roughly 160 subscribers include reinsurers, insurers and corporate entities that purchase coverage through their captives, Mr. Sweeney said. "We obviously have a long way to go, but we are pretty satisfied with what we have achieved so far," Mr. Sweeney said. The exchange sees increased activity after major losses, as cedents seek to buy replacement coverage to offset depletions in their existing cover, he said. For example, Mr. Sweeney said, there was a flurry of activity after the European windstorms in December last year. Last September, the Chicago Mercantile Exchange entered the field of insurance-related derivatives when it began offering weather derivatives . Thus far, 420 futures contracts have been traded, said Larry Grannan, senior director in product marketing at the CME. Such contracts are designed to allow businesses to hedge against weather-related losses. For example, a utility may sell less power in a mild winter, and it would be able to use the futures to hedge a resultant fall in revenues. The exchange first offered heat-based indexes for Atlanta, Chicago, Cincinnati and New York. In January, it added Philadelphia, Dallas, Des Moines, Las Vegas, Tucson and Portland, and it began offering contracts based on cold weather. Currently, most of the trades are between securities dealers themselves, but, eventually, the contracts will likely be used more extensively by utilities and insurers, Mr. Grannan said. In addition, the futures contracts could be used as hedges for over-the-counter securitized deals, he said. Copyright , 2000 Dow Jones & Company, Inc. All Rights Reserved.
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