PCS working with CSX to develop catastrophe derivatives exchange

In what could prove to be one of the most important developments in the catastrophe reinsurance market in some time, Property Claim Services (PCS) has announced that it is working with the Cayman Islands Stock Exchange (CSX) on an initiative to launch exchange traded catastrophe derivatives on the CSX.

Trading in catastrophe risk on exchanges is a venture which has been attempted a number of times. In fact PCS was the first, with its support of a PCS options exchange hosted by the Chicago Board of Trade (CBOT). Other attempts at providing exchange trading for catastrophe risks include the IFEX exchange, which closed down a few years ago after attracting little in the way of trading and the Chicago Mercantile Exchange (CME), which still offers hurricane futures and options alongside its weather risk management products.

The complaint about some attempts to launch catastrophe options, futures and derivatives, has often been related to the instruments being too complex and not based on a simple and easily understandable underlying index. The CME has never really gained broad market acceptance of its hurricane instruments, with market participants often citing the underlying index as too opaque.

The market has often called for simpler instruments to be made tradeable on an exchange, perhaps parametric or binary in nature, or based on an already accepted index which can be used as a trigger and measure of losses. The PCS catastrophe loss index is widely used across the reinsurance market, so perhaps this venture stands a chance of gaining broader traction than some which have gone before it.

The PCS options which were listed on CBOT received a lot of attention in the late 1990’s when they launched, even being heralded as a zero-beta asset which investors could appreciate non-correlation from, according to one study. We’re not sure why that venture ended, perhaps it was too early in the development of the wider insurance-linked securities market (ILS) for exchange traded options to succeed.

PCS have entered into this venture alongside the Cayman Islands Stock Exchange (CSX), a stock exchange with full electronic trading facilities thanks to its adoption of the Deutsche Boerse XETRA platform, after which it said that it would like to make the catastrophe bonds and ILS listed on the CSX tradeable through the system.

So the CSX is no stranger to ILS and catastrophe bonds, having a good proportion of the market listed on its exchange, which for PCS, along with the technology at its disposal, made it a good partner for the venture.

PCS said that the instruments that will be traded on the CSX are perhaps best thought of as similar to an industry loss warranty (ILW). These are an insurance derivative contract which is triggered based on industry losses from a catastrophe event. PCS catastrophe loss data is the most widely used source of data for ILW triggers, so applying a similar philosophy to these exchange traded catastrophe derivatives makes perfect sense.

The instruments which will be traded on the CSX will be a derivative, linked to an underlying catastrophe loss index provided by PCS. The derivatives could be for any size of loss, structured by U.S. state, by line of business across personal, commercial and auto lines, as PCS data is currently available.

So an insurer could list a $20m catastrophe derivative for sale on the exchange, for example for a $200m Ohio auto loss. That would provide it with $20m of protection against a catastrophe event such as a severe hailstorm impacting many automobiles in the state. A counterparty would buy the derivative, thus providing the protection, on the basis of receiving a premium return. Premiums would be defined by the seller at the time of the listing.

That’s a very niche example, a broader one might be a catastrophe derivative which covers all U.S. east coast states for hurricanes causing a $30 billion or higher industry loss across all lines of business. Perhaps this might be a $100m catastrophe derivative and perhaps there might be a number of counterparties buying into the deal as a syndicate, something PCS and the CSX would like to be able to offer once the exchange instruments are up and running.

There are many use-cases, from insurers looking for reinsurance, to reinsurers looking for retro, to ILS funds looking to hedge the risks they hold, to a Florida orange grower wanting to hedge the hurricane season with a small catastrophe derivative. All could be supported by this venture in the future PCS hopes.

So, the main question for PCS and the CSX on this new venture is what is different and why they feel that now is the time for exchange traded catastrophe derivatives to be launched?

Joe Louwagie, assistant vice president of PCS, told us; “We pursued this initiative because it aligns closely with our mission to serve the insurance industry and the ILS Community.  Having PCS available as a listed option on the CSX facilitates risk transfer, further enables growth of the insurance-linked securities sector, supports the entire insurance mechanism, and most important to us provides a service to our customers.”

That’s all that we have in the way of detail on this latest initiative from PCS alongside the CSX. It’s a timely announcement, with much of the reinsurance and ILS market gathered in Monte Carlo for the annual reinsurance Rendezvous.

It will be interesting to see how this initiative develops. PCS declined to give us a timetable for when it thought the exchange traded catastrophe derivatives might be available to trade on the Cayman Islands Stock Exchange, but said that planning and preparation was now underway and a timetable would be decided on in the coming weeks.

We’ll bring you more on the plans as they move forwards and hope to bring more detail on the instruments that will be tradable when it becomes available.