the Bermuda Commodities Exchange. Business writer Ahmed ElAmin analyses a long-awaited development After three years in the making The Bermuda Commodities Exchange (BCOE) will begin trading in about two months, creating an electronic marketplace and a new set of options contracts for hedging and investing in catastrophic insurance risk.

Members of the exchange will conduct options trades using a secure electronic computerised system which allows them to post prices and volumes anonymously.

"You will see bids and offers at every price and quantity but you will not see the identity of the member who put it up,'' exchange president Thomas Heise said. "It's a virtual trading pit. It's like a trading pit where everybody has a mask on.'' Options are a specialised type of investment instrument usually used for betting on what will happen to the price of a certain commodity in the future.

Here the commodity will be insurance risk, and the determining factor will be the amount of losses due to catastrophes which occur in the US during a certain period.

The options contracts being created will allow reinsurers to hedge off some of the risks they assume to investors outside the industry, giving the companies the ability to cover more business. They will be able to use the new source of capital to protect themselves against infrequent but potentially devastating losses. For investors, the contracts will allow them to directly purchase catastrophe risk as a new form of investment. They will be betting against catastrophes occurring.

The founders hope that by bringing potentially hundreds or thousands of investors into the market will help spread the impact of these huge but infrequent losses.

Eventually, with enough volume and competition for the contracts, the exchange could be a move towards stabilising pricing in the catastrophe market, where volatility is the norm depending on the frequency of earthquakes, fires, floods, riots, and other such catastrophic events which cause billions of dollars worth of losses.

Initially though, the options contracts will be based on the US east coast region and will only cover wind, storm, freezing rain, hail and snow related risks. Mr. Heise said the region was chosen to start with as that's where there is currently a demand for additional catastrophe reinsurance coverage.

Through the contracts investors will be assuming some of the reinsurers risks in the region, for a specified period, for a specified type of loss correlated against the movement of a specially created catastrophe index.

The contracts, worth $5,000 each, will cover six-month periods for the US divided into Florida, Northeast, Southeast, Gulf area, Mid/West and National regions. Contracts will cover damage from a single event, aggregate or second event loss over the covered period.

An investor could therefore buy options contracts in a variety of combinations based on time and region.

"Typically it will be a Bermuda cat company who is using these contracts,'' Mr. Heise said. "They will own Florida risk because they are reinsuring other reinsurers or are reinsuring primary insurers that have it. When they use the Florida products on the exchange they will be using combinations of losses, on a time, and geographical basis.'' New exchange bodes well for Bermuda Once an investor buys a reinsurance contract option he will receive a premium payment from the insurance company. The contracts will be based on the performance of an index created by IndexCo, an affiliate of Guy Carpenter & Co., Inc.

In a sense the investment instruments being created by the BCOE are not options in the usual sense. Options in the investment market give people or institutions buying them the right to buy or sell a specific investment at a set price within a preset time period. The option may deal with a stock, index, Treasury bond, currency, or even more esoterically a futures contract.

There is some sort of underlying investment behind the option. The options are then traded in time at a specific strike price, set by the exchange depending on the performance of the underlying investment on which the option is based.

The investor will then pay or receive a specific amount on the underlying commodity depending on the strike price.

At the BCOE investors will get a premium on their option purchase of insurance risk. The premium payment will be the price the investor gets for assuming $5,000 worth of risk per contract from the insurance company. They may trade their positions during the life of the option, but at the settlement of the option investors will either receive all of their $5,000 back per contract, or nothing depending on whether the Guy Carpenter Catastrophe Index falls or rises beyond a set strike price.

"Each contract on the exchange possesses $5,000 worth of insurance risk,'' said Mr. Heise. "You can't touch taste or feel it, but it's there. It's an option in the sense that it has a strike price which is what the index value is at the end of the contract.'' Setting up the index is a key to the exchange working. It is designed to measure the amount of insured damage to homes in the US from atmospheric perils, and combines the loss experience of 39 insurance companies. The index calculates losses against property values according to 12,000 individual zip or postal codes. For each geographic area covered by the index, two types of indices are produced, an event one which measures the damage from a specific catastrophe, and an aggregate one, which measures the total atmospheric damage in an area during a specified period of time.

Combining all the factors involved in the exchange gives a wide variety of options that can be created.

"You could potentially have about 1,000 combinations with two risk periods, a single event, aggregate and second loss, six regions, and strike prices,'' Mr.

Heise said. "The strike is the index value. There are 17 values which represent the ratio of paid losses to total insured value in the region. That determines whether or not the option is worth $0 or $5,000. You could have the Florida July 1997 at a strike of five. His $5,000 is held until it's settled.

If the index published at four he gets his $5,000 back plus his premium, which he received the day he put his position on. If the index settles at six the reinsurer gets the $5,000 of protection that they bought because the reinsurer knows if the index went over five he would have had a loss on his original reinsurance contract.'' Those likely to become members of the exchange include financial institutions, insurance companies, and intermediaries.

The initial 100 members of the exchange are expected to include affiliates of insurance giant American International Group, Inc. (AIG), Chase Manhattan Bank, the largest bank holding company in the US, and Guy Carpenter & Co., Inc., a leading reinsurance intermediary, Goldman Sachs & Co., and some of the reinsurance companies based in Bermuda.

Transactions will be cleared and settled by the Bermuda Commodities Exchange Clearing House, which will be majority owned by AIG. Chase, Guy Carpenter, and a private partnership which Mr. Heise belongs to, will also have equity stakes in the clearing company.

Mr. Heise said the founders decided to base the exchange in Bermuda as between one-quarter and one-third of catastrophic cover risk was underwritten by companies based here.

If the concept works, and there are some big money players backing it, the exchange could eventually help boost Bermuda's position in the reinsurance market.

Similar exchanges have been set up around the world, specialising in different commodities. The London International Financial Futures Exchange for example allows futures trading in European bonds and currencies. Singapore has developed an exchange that trades on Asian stock indices. The 20-year-old New York Mercantile Exchange trades in oil futures. These were all created to meet a need in a specific industry, giving companies the ability to protect their bottom lines against fluctuations in the prices of the various commodities.

"The BCOE is a logical progression for the insurance industry, created by the insurance industry,'' Mr. Heise said. "The more activity you have the closer you get to what is the natural price of the risk. If you have enough capital -- we don't know what that is -- you will have what's called price discovery.

And that's the function of the market discovering what's the natural price of the risk. The price of the risk will be the premium payment. That can only occur when you have incredible competition for price. That could be higher than today's price. It could be lower. Nobody knows.'' Mr. Heise was the former director of reinsurance and financial planning for the American International Group. He also served as vice president of mergers and acquisitions for Near North Insurance Brokerage, the fifth-largest private commercial insurance broker in the US. He was also a senior consultant at Arthur Andersen & Co., specialising in corporate recovery services. He began his career as a sales account manager for NRM-Steelastic, a supplier of capital equipment to the tyre industry.