Will Hurricane Matthew Trigger A Derivatives Melt-Down?

“Catastrophe swaps” – aka “weather derivatives” – are an obscure derivatives “Frankenstein” created under the auspices of helping property & casualty insurers and re-insurers to “transfer” a portion of the risk on a portfolio of catastrophe insurance to the “marketplace.”

In reality, it was just another Wall Street mechanism designed to generate huge fees for Wall Street derivatives bankers.   Without a doubt, just like financial market OTC derivatives and “portfolio insurance,”  these derivatives were significantly underpriced relative to the true statistical expected value of the contract.  After all, if the cost of weather catastrophe protection carries a high premium, it wouldn’t generate much sales volume and thus wouldn’t generate fees for Wall Street.

Florida has addressed the problem of the cost of hurricane insurance by creating a State run insurance fund – the Citizens Property Insurance Corporation – to provide hurricane insurance to those who could not otherwise afford to pay the premiums in the private insurance marketplace.  Notwithstanding the fact that anything like this run by any government will eventually lead to undesirable results, that fact that cost of hurricane risk insurance had to be socialized in Florida reflects the fact that the expected value of the cost of  insuring against hurricane damage is higher than most households can afford.

The truth is, if you can’t afford the cost of hurricane insurance, that you should not be living in home that is potentially subjected to hurricane damage.  Move inland.

But Wall Street decided to “fix” this problem by rolling out weather derivatives.  The entities who would want to buy protection from a hurricane would be insurance companies – like the Citizens Property Insurance Corporation.   The entities who would take the other side of that would be, of course, hedge funds.   For Wall Street, the trick in pricing the cost of these derivatives is to find the price-point at which buyers would be willing pay for it – so it has to be less than the cost of re-insurance – and the price-point at which hedge funds would be tempted to take the risk in exchange for cash upfront.

It’s a three-headed greed monster:  Wall Street, insurance companies and hedge funds.

These derivatives enable insurance companies to take on higher risks than they would otherwise if these products were not available, or were priced properly, and they enable hedge funds to take in cash to use in other speculative endeavors.  And they let Wall Street whores skim large fees  – all for a price that everyone can live with.

That is, of course, until an event occurs for which the probability of that event occurring was not properly priced into the equation.   If the true risk embedded in exotic OTC derivatives were priced into these products, no one would buy them.

Just like the “portfolio insurance” of the 1980’s, the “hedge” models used by Long TermuntitledCapital  Management and the derivatives pricing models used by entities that were blown up by mortgage derivatives less than ten years ago, these weather derivatives are going to blow a big hole in some insurance companies and hedge funds if Hurricane Matthews is what it’s reported to be.  It’s called “counterparty default.”  It’s Jame Dimon’s “tempest in a teapot” that all of a sudden blew apart the teapot.

If Matthews inflicts the kind of damage on the east coast of Florida that is now being predicted, there will be hedge funds who will be unable to make payments when the insurance companies come to collect on their side of these weather derivatives agreements.  The most interesting to watch will be the Florida State fund.   If its reinsurance and weather derivatives counterparties default on payment, the State of Florida could end up in serious financial trouble.

On the private insurance side of this, there’s no doubt that P&C companies underwrote risks that they may not have underwritten if weather derivatives were not available.  But in addition to buying catastrophe swaps, portions of the exposure would have been laid off on reinsurance companies.  When claims pour in that exceed the amount set aside for those claims, the insurance companies will look to the re-insurance companies for payments who will turn to hedge funds who underwrote the weather derivatives.  When the hedge funds default on these claims, that’s when the fun begins.

 

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Dave Kranzler

I spent many years working in various analytic jobs and trading on Wall Street. For nine of those years, I traded junk bonds for Bankers Trust. I have an MBA from the University of Chicago, with a concentration in accounting and finance. My goal is to help people understand and analyze what is really going on in our financial system and economy. You can follow my work and contact me via my website Investment Research Dynamics. Occasionally, I publish on Seeking Alpha too. As a co-founder and principal of Golden Returns Capital, LLC Mr. Kranzler co-manages the Precious Metals Opportunity Fund, a metals and mining stock investment fund.