With Irene bearing down on the East Coast, the thought of hurricanes on my mind. Believe it or not, there is an options tie-in.
As many of you know, there are a lot of similarities between options and insurance. So much so that when you buy either, what you pay is described as ”premium”.
With insurance, you are spending money to protect your financial situation in case of an adverse event. It won’t prevent the event, just the financial impect.
Options are more flexible than that. But one of the most important ways in which they’re used is to protect one’s financial situation in case of an adverse market event. Like insurance, a protective option won’t prevent the event. But it will mitigate the financial impact.
There are other similarities, including the ways in which both are evaluated: expected return analysis. Both options and insurance have a limited duration. There’s also a commonality with strike price and deductible. The list goes on.
But there is one key difference: insurance pricing is regulated, option prices are not. With options, a put can be $1 at 10 am and $100 at 11. There is no limit to the price increase, as long as the the underlying asset is trading.
Insurance policy price increases, on the other hand, are limited in most states. For instance, after the hurricane cluster in Florida in 2004 and 2005. Options have no such limitation.
That’s why, with options, you won’t see stories like this Reuters story I’ve been saving for the past 8 years  (couldn’t find a link, it’s so old):
Insurers: No Policies Ahead of Isabel
Tuesday , September 16, 2003
NEW YORK — Homeowners on the East Coast shopping for insurance ahead of Hurricane Isabel are finding themselves out of luck.
Several of the biggest home and auto insurance companies, including State Farm, Allstate Corp. and Nationwide Financial Services Inc., have stopped issuing insurance to those in the direct path of Isabel, according to company spokesmen.
As of Tuesday, the hurricane was still hundreds of miles out in the Atlantic Ocean but moving steadily on a path that would bring it ashore on Thursday on North Carolina’s Outer Banks, then north through Virginia, and the state capital Richmond.
But even though a weakened Isabel is unlikely to cause damage on the scale of Hurricane Andrew, it still could be a multibillion dollar event for the insurance industry, according to analysts. Andrew cost insurers nearly $20 billion, making it the most costly storm ever, according to the Insurance Information Institute.
Halting insurance policy issuance ahead of an imminent catastrophe is standard industry practice and a way for insurers to avoid unnecessary risk.
“You don’t want to insure a burning house,” Insurance Information Institute spokeswoman Loretta Worters said.
Allstate’s moratorium, which went into effect Tuesday, halts new policies or changes to existing policies throughout North Carolina, along coastal South Carolina and potential impacted areas of Virginia, according to company spokesman Mike Trevino. It also applies to boat and maritime insurance in Connecticut, Pennsylvania and New York, he said.
State Farm’s halt affects all of the areas where the hurricane watch is in affect, spokesman Kip Biggs said.
But auto insurer Progressive Corp. (PGR) had no restrictions on new polices and spokesman Tom King said that, in general, cars suffer less damage in a hurricane than homes.
“When hurricanes hit, people tend to get in their cars and drive away from the coast,” said Progressive spokesman Tom King. “You can’t move your house.”
Elizabeth Benton at the Lewis Insurance Agency in Wilmington, North Carolina said on Tuesday she had to turn down many customers seeking to change their policies to include wind damage as the storm approached.
“They will be calling right up until the last minute,” Benton said.
This isn’t surprising. If you see a hurricane coming, would you want to sell hurricane insurance at the same price as you were selling it when the weather was perfect?
Now think of the stock market, and the financial storms we’ve seen recently. No matter how bad the storms got, even in the midst of the storm you could by insurance on your portfolio. The price of that protection may have been abysmal, but at least you had the opportunity to make that decision.
In other words, with options, you CAN buy insurance on a burning house and there will always be someone there to sell it to you.
– Don
