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.
He said for the 2011 hurricane season 3,700 contracts have been traded, or are "outstanding." If all of this year's contracts are redeemed, or paid out, they will be worth $37 million. But that is unlikely.
Hurricane contracts are "all or nothing" bets. Purchasers only receive a payout after the hurricane season and only if they are accurate with their prediction.
Because there were no major hurricanes in 2010 and 2009, there were no payouts. In 2010 there were 3,875 outstanding contracts and in 2009, there were 4,000.
Banks even hire meterologists to assist in trading commodities like soy and wheat, which are heavily influenced by weather.
Matt Rogers is a meterologist and president of Commodity Weather Group, a consulting firm for energy and agriculture commodities.
He said hurricane contracts and other weather derivatives can offer help to companies that hedged their bets in the financial markets.
"It doesn't matter if you have proof or damage or not," he said. "Hurricane contracts could offer a faster payout than an insurance policy would, depending on the liquidy of the market."
Peterson said the payout will not occur until early January, after the hurricane season ends and the contracts expire.
It is unclear how much damage has actually occurred until the cleanup process is complete, especially for the unexpected effect of flooding. And most homeowner's policies usually do not cover loss due to flooding. But coverage for future flooding coverage can be purchased from the federal government through the National Flood Insurance Program at 1-800-427-4661.
Alice Gomstyn and Colleen Curry contributed to this report.