Insurers Find Hurricane 'Insurance' on Wall Street

Aug. 30, 2011 — -- Insurers and utilities who face major losses related to Hurricane Irene may find some help, not from the federal government, but Wall Street. Insurance and utility companies, which stand to lose from the billions of dollars in damage from Hurricane Irene, can bet how much damage will incur during hurricane season through financial products. And if their bids are accurate, they could receive a payout.

Commodity traders began investing weather derivatives in 1999 when they were introduced by the Chicago Mercantile Exchange (CME), which has the world's largest options and futures contracts outstanding.

The CME developed hurricane futures and options contracts in 2007 following the damaging 2005 hurricane season, which included Hurricane Katrina.

Hurricane contracts are analogous to insurance premiums for insurers, utility and energy companies, state governments, and other market participants, to hedge against potential hurricane risks, said Paul Peterson, director of CME's commodity research and product development.

Hurricane Irene's damage could reach $7 to $13 billion in losses through 10 East Coast states despite it making landfall only in North Carolina and New Jersey in the continental U.S.

Companies that want to trade, or purchase, a hurricane contract can only so at the beginning of the hurricane season, which runs from June through November. They estimate the potential damage in a hurricane season from the southern tip of Texas to Maine's border with Canada. Traders do so by placing their bets on the wind speed and radius of a hurricane and the CME has a formula to measure the potential damage using publicly available data from the National Hurricane Center.

"Insurance companies are not necessarily concerned about number of storms or severity of a storm – they're worried about damage over whole season and the dollar value of insurance claims," Peterson said.