IFEX Event Linked Futures (ELFs)

IFEX Event Linked Futures (ELFs) are futures market versions of 'Industry Loss Warranties' (ILWs). ILWs are reinsurance contracts triggered by pre-determined losses to the insurance industry in excess of specified amounts and by specified losses to the insurers and reinsurers which have bought the coverage. ILWs are usually ‘binary’ or ‘digital’ contracts with the payment triggered in full once loses have reached the pre-specified amounts. IFEX ELFs are binary futures contracts and have the same structure.

IFEX ELFs are contracts for difference and NOT reinsurance contracts. IFEX ELFs have similar economic characteristics to ILW reinsurance policies except that buyers of the contracts do not have to suffer losses to receive a payment once the industry loss strike amount has been reached.

IFEX ELFs (US Tropical Wind)

IFEX currently trades annual 2008 and 2009 ELF US Tropical Wind First Event contracts. In due course, Second Events will be listed.There are five Loss Trigger Levels (LTLs) :  $10bn, $20bn, $30bn, $40bn and $50bn.

IFEX ELFs follow the pattern of the reinsurance market in being event based. Thus If Hurricane Alpha caues $10.1bn of damage, it will trigger a payment of the $10bn First Event Loss Trigger Level. If then Hurricane Beta causes losses of  $21bn it will trigger the Second Event $10bn Loss Trigger Level and the First Event $20bn Loss Trigger Level.

The loss estimates which trigger payments under the contracts are estimated by Property Claims Services (part of the Insurance Services Organization) a major provider of information to the insurance industry. 

Reinsurance and Capital Markets Convergence

One striking development over the last decade has been the convergence of reinsurance and capital markets. A major development has been the growth of an active market in catastrophe bonds The introduction of ELFs is another step in this process of applying capital  market techniques to reinsurance.

 

Why ILWs?

ILWs are an important part of the reinsurance industry. The market is transparent and contracts are largely homogeneous in structure and risk. The use of ILW reinsurance contracts increased sharply after the major hurricane losses of 2005 when Hurricanes Katrina, Rita and Wilma (KRW) caused insured losses of $81.5b. Limits are for between $5m and $50m and over the year to mid 2007, $5bn of capacity with premiums of between $500 and $600m was underwritten.

 

Uses of Event Linked Futures

IFEX ELFs have been designed to replicate the structure of ILW reinsurance contracts as contracts for differnce in tradable form. Uses will  include:

• Hedging of cat bond and ‘cash market’ ILW portfolios.
• Hedging cat exposed equities – insurers and reinsurers.
• Using future year contracts (2009) to hedge cat insurance price risk – hedging the price of renewals both as writer and buyer.
• Increasing or decreasing exposure to US Tropical Wind.
• As supplements to inwards and outwards reinsurance programmes.
• Exploitation of mis-pricing compared to technical rates.

Future Developments

 

More Contracts  IFEX does not intend to stop with the introduction of ELFs (US Tropical Wind). It is planned to launch equivalent contracts for other catastrophe zones including European and Japanese risks, together with US catastrophe sub-zones. 

Dynamic Reinsurance Hedging  It is also planned to develop a transformer facility will allow insurers and insurers to convert IFEX ELFs (contracts for difference) into reinsurance contracts. In turn this will allow protection buyers to continuously monitor and adjust their reinsurance programmes – dynamic reinsurance hedging.

Improved Margining  IFEX also plans to launch a improved margining system which will lead to reduced margin for both writers and buyers. The current margining system requires buyers and sellers equivalent to their maximim possible loss.