Weather and the Insurance Industry - part 2

With the threat of an increase in the frequency of events such as hurricanes, the industry researchers who determine their likelihood have to make a few changes.  Regions such as the Gulf Coast already face problems with insurance, in such high-risk areas the cost of property insurance is sky-high and are only set to increase.

In my opinion, the Insurance industry is not fit for these events, and as a result they increase prices. The potential to make huge losses in the future is large.  The insurance market is inherently unsuitable for natural disasters.  Yet insurers still try to make it work in hazardous areas by increasing prices, in the hopes that they can afford to pay out the necessary funds if and when hazard occurs.  With this in mind it is clear that there could be opportunities that exist to ‘go short‘ in the future.

A brief and extremely simplified explanation of going short: Options give an investor the opportunity to go long or short on a company’s shares.  When an investor goes short, he or she has purchased a put option on the underlying security, expect the share price to be lower than it is today.

There are possibilities in the future for market analysts to find out which particular properties in particular areas could be more vulnerable to adverse weather conditions, and thus which insurance companies may have to pay out large sums of money in the future given that natural disasters are set to continue and potentially increase.

While I believe there may be increasing interest in the options market in insurance given an increase of natural disasters in future, we will certainly see increased activity in shorter duration financial activities such as spread betting. Spread betting essentially has the same payoff structure as options but is processed in a much short time frame, in the order of hours/days.  For example, one may expect to see much more activity in spread betting on insurance shares as scale five hurricane approaches the gulf coast. 

This paper by B. Blau et al.  (2008) Looks into how investors are profiting because of hurricanes Katrina and Rita, and after observing the effects of Katrina on the shares prices of insurance companies how their behavior adapts during and prior to Rita. 

References-

Diamond, D. Verrecchia, R.  (1987) Constraints on short-selling and Asset Price Adjustment To Private Information, Journal of Financial Economics 18 (1987) 277-311. North-Holland

Immergluck, D. (2011), Critical Commentary. Sub-prime Crisis, Policy Response and Housing Market Restructuring, Urban Studies