CME hurricane index contracts could payout as quickly as five days after landfall

by Artemis on November 21, 2011

The Chicago Mercantile Exchange (CME) has for a number of years been offering hurricane futures and options to anyone seeking to hedge the risks of landfalling hurricanes impacting their bottom line. Users of these contracts are generally re/insurers, some hedge funds, ILS funds and investors with exposure to specific storms and certain corporates with hurricane exposure such as offshore energy companies (although they usually transact through brokers).

The products have been quite successful, but in our opinion there can be a lack of understanding of the CME hurricane contracts in the wider re/insurance markets and how they could be used to enhance coverage for specific storms or seasonal U.S. hurricane exposure. One of the major benefits of these contracts that should appeal to the re/insurance market are the speedy payout that can be achieved from certain hurricane futures or option.

The CME hurricane index futures and options are based on the CME Hurricane Index (CHI), a proprietary index which risk modeller EQECAT provide calculation services for. The CHI index values are derived from publicly available data from the U.S. NOAA National Hurricane Center, taking into account a storms unique characteristics such as radius (or size) and wind speeds, along with the location of landfall, to produce CHI index values which reflect a hurricanes damage potential.

The CME says that hurricane Irene was a good example of how readily a payout can be received under the terms of certain CME hurricane contracts. For hurricane Irene preliminary CHI index values were produced within three days of the first landfall, remember Irene made two landfalls, the first in North Carolina and the second 12 hours later in New Jersey.

Depending on which type of hurricane contract was used, said the CME, payout could have been made as soon as five days after the first landfall. They say this shows one of the core benefits of these hurricane contracts when compared to other tools such as reinsurance or catastrophe bonds which can take longer to payout.

At least one hurricane contract was thought to have been triggered by Irene, specifically due to the unique way the CHI classes each landfall as separate events (there are some rules as to what comprises a second event) as it was a second event contract.

The CME had already seen record levels of hurricane futures and options traded on the exchange by mid-October this year, with hurricane derivatives trading hands over 4,000 times. This despite the U.S. hurricane season being fairly benign again. A more active season with more storms threatening U.S. landfall could see the CME hurricane contracts break volume records again next year.

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