“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.
As you can imagine, a hurricane can cause a lot of property damage. From ripping the roofs off homes to blowing down walls, homes can be ruined in a matter of minutes. After the hurricane passes, repairs need to be made by professionals like those from a Blue Ladder Roofing Company as well as plumbing companies, electrical companies, and sometimes even landscaping companies if trees have been uprooted. These repairs are essential if a family wants to return to their home. Thankfully, some families have hurricane insurance which can help cover the cost of repairs but sometimes things don’t always run smoothly. Hurricanes can lead to a lot of complications when it comes to insurance disputes and companies handing out money to property owners. This often causes insurance prices to rise more and more over the years. However, 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, the 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. Some people can find deals on sites like Covered, but this is not universal.
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. A lot of the damage may not be totally devastating but may involve something like a damaged gutter that has either been broken or clogged with debris from the storm. In this case, Floridians living on the east coast may want to look towards something like the services from Clean Pro Gutter Cleaning Fort Lauderdale in order to repair or clean the affected gutter.
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 Term Capital 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.
No problem: the Fed will be able to easily print the required the amount of dollars to repair the cars, the furniture and houses…
I have no doubt any more that the looting, in one form or another, will continue until the masses are living like they do under Mugabe. There won’t be any political reform any more then there will be in Zimbabwe. The vote in Hungary on immigration is a good example, nearly all who voted were against unsustainable immigration of refugees, less than 50% voted though so the vote didn’t count. Those voting were probably the middle class that are doing all the heavy lifting. Those sucking on the government teat don’t care or don’t know. That includes those at the bottom and those at the top. Of course, for those at the top the system is working perfectly. Dilute the power of the middle class and set the game up so they can only lose.
It is so bloody obvious.
Not caring is about the only defence I have any more. No so easy to do though.
In addition to what you mentioned above, real estate losses and banking losses are real possibilities. Insurance premiums will most likely increase. Insurance is mandatory for anyone in Florida looking to buy a home or who already owns a home with a mortgage. We could see the real estate market decline rapidly because of increased carrying costs and that might blow a hole in the mortgage business. Brick and mortar Buisnesses will also be adversely affected. If insurance costs increase enough, a lot of businesses will be forced to move out of state or close up shop unless they can pass their increased costs onto their clientele.
just the first 5 minutes but looks like they are hammering every uptick in gold post BLS # miss, how can you beat produced out of thin air shorts other than a delivery event
The Chinese are coming back from vacation next week. The fools in charge don’t want to create a gaping SGE arbitrage opportunity. Therefore, prices will go up before Monday. This might be a re-occuring event. If so, the next major Chinese holiday is between Jan 27-Feb02 (Chinese new Year). I’m going to buy GLD puts right before Jan 27th. Then load up on some of Dave’s miners.