A novel financial market structure for mitigating hurricane risk

Increasing coastal development coupled with some very active recent hurricane years have severely stressed the capacity of the U.S. insurance industry to absorb financial risks associated with hurricane damages. As a result, access to hurricane insurance has been progressively limited, costs to purchasers have increased, and financial protection against some consequences of hurricane strikes (e.g., business interruption) is effectively unavailable.

This talk will describe a novel approach to mitigation of financial losses resulting from hurricane landfalls, based on quantitative assessments of the uncertainty. Market participants buy contracts (formally, commodity options) from an exchange, which pertain to hurricane landfalls at defined coastline segments from Texas to Maine. The prices for these contracts vary through time in proportion to the probability that the next U.S. hurricane landfall will occur at a particular coastline segment, as assessed through an adaptive control algorithm that responds to different levels of buying for the different coastline segments. Proceeds of these sales are collected into a common ("mutualized risk") pool, and holders of contracts for the coastline segment eventually experiencing the landfall are paid from this pool in proportion to the number of contracts held. This market structure efficiently spreads hurricane risks across the entire Gulf and Atlantic coasts of the U.S., on the basis of the uncertainty regarding landfall location as quantified by probability assessments for the event; and without requiring a counterparty, i.e., someone other than the exchange who is willing to sell the contract.