Carvill Offers Options on Individual Named Storms

Carvill Capital Markets recently listed named storm contracts on the Chicago Mercantile Exchange providing coverage for live hurricanes and for an entire hurricane season.

Patrick Gonnelli, president of Carvill Capital Markets, said contracts are listed on the CME, allowing any company or individual with exposure to hurricanes ranging from rig owners, insurance companies, reinsurance companies and hedge funds to purchase the product.

“There was a lot of interest generated during Hurricane Gustav,” Gonnelli said. “Our Cat (catastrophe) in a Box contract covers 90 percent of the oil rigs located in the Gulf; there were no trades completed for Gustav but we had a lot of bids and offers.”

Carvill has traded $60 million of notional limit thus far through the CME, and has received $450 million of bid and offers, according to Gonnelli.

So-called binary hurricane options are the newest additions to the family of CME-Carvill Hurricane futures and options products. They are similar in many respects to standard options on futures, with strike (exercise) prices on a wide range of Carvill Hurricane Index values, but with a number of important differences. The hurricane contracts provide the option holder with a fixed dollar payout upon exercise. That is unlike standard options, which provide the option holder with a position in the underlying futures contract, and the value of that underlying futures contract may vary widely depending on market conditions.

Carvill is the reporting agent for the Carvill Hurricane Index and reports the formulaic value to the CME when a hurricane makes landfall. The publicly available formula to determine the CHI value is based on a storm’s radius and wind speed. The company uses the National Hurricane Center’s public advisories to get those measurements.

Gonnelli said although this is the first hurricane season the product is being offered, contracts settle within 72 hours of landfall.

“We had an official CHI value for Gustav one hour after it made landfall. There has been a lot of interest from the energy sector,” he noted.

As options that are traded over the counter — not via a click and buy market — Carvill Capital Markets acts as the CHI broker that matches up bids and offers and executes the trades through the CME, according to Gonnelli.

Steve E. Smith, president, of Property Solutions, ReAdvisory/Carvill America, said wind speed is the primary cause of damage to properties during a hurricane event. The size of a hurricane is also a significant factor because larger storms cover a wider area.

Smith believed improvements can be made to current hurricane classification schemes that are generally based on the Saffir-Simpson Hurricane Scale developed in 1969 by Herbert Saffir, a civil engineer on commission from the United Nations to study low-cost housing in hurricane-exposed areas, and Robert Simpson, the then-director of the National Hurricane Center.

“This would appear to be a good moment in time to consider whether the tools used by the (insurance) industry, and society in general, are adequate to describe hurricanes and manage exposures,” Smith said. “While the SSHS has been widely used to date, there are a number of features which make the scale less than optimal for use by the insurance community, and the public at large.”

The SSHS is used in the Atlantic and Northeast Pacific basins to estimate the potential flooding and property damage, given a hurricane’s intensity, Smith said. Saffir used the Richter scale, which describes earthquakes, as the inspiration for his scale that ranged from one to five, measuring wind speed to the expected damage on structures. The Simpson scale contributed to the scale by adding the effects of storm surge and flooding, according to Smith.

“The SSHS has only five categories,” Smith pointed out. “A storm with a wind speed of 111 mph is classified as a Category 3 storm. However, a storm with a wind speed of 110 mph is classified as a Category 2. This change of just 1 mph implies the potential for damage changes by one whole category (20 percent), even though the intensity has changed by less that 1 percent.’

Smith said that situation has led to meteorologists quantifying Saffir-Simpson categories as either strong or weak; for example Hurricane Katrina was a strong Category 3 storm at landfall.

Smith said a more useful scale would be continuous rather than discrete, and noted that the Richter scale is a continuous scale.

Smith said being able to rate a hurricane as it approaches landfall is crucial for emergency response and planning, and the Saffir-Simpson Scale’s structure and lack of complexity are disadvantages. He said the Carvill Hurricane Index accounts not only for the maximum sustained wind speed of a hurricane but also for the size of the storm, making it a useful tool in determining the potential for damage from a hurricane.