A home price insurance policy offers a homeowner the ability to
insure himself or herself against losses incurred due to falling
home prices between the time the policy is purchased and the time
the insured's home is sold (if the policy is still in effect). In
order to offer such a policy at an affordable premium, an insurer
must be able to minimize its losses (claims paid) should the risk
event (prices are lower when the home is sold and the policy is
in effect) crystallizes. This invention provides a method for using
put options on housing futures contracts to price a home price insurance
policy appropriately today and hedge claims risks in the future.
1. A method for using options on housing futures contracts to determine
the premium an insurer will quote its customer that is comprised
of the following steps: (a) Using the inputs of a potential customer's
current home value, term of policy, and location of home, an insurer
prices put options on housing futures contracts in the same metropolitan
area and with the with the same duration and value; (b) The insurer
then adds desired profit and estimated overhead expenses to the
cost of the options on housing futures contracts to determine the
premium to be charged to the customer.
2. A method for using put options on housing futures contracts
to hedge the claims risk of a home price insurance policy that is
comprised of the following steps: (a) If the customer purchases
the home price insurance policy, the insurer actually purchases
the put options on housing futures contracts that were priced to
determine the premium in claim 1; (b) If the housing price index
for the metropolitan area covered increases or remains the same
during the term of the policy, the insured is entitled to no claims
and the insurer allows the put options on housing futures contracts
to expire worthless; (c) If the housing price index for the metropolitan
area covered decreases and the house is sold during the term of
policy, the insurer will either sell the put options on housing
futures contracts or exercise them and utilize the profits to pay
the insured's claims.
BACKGROUND OF THE INVENTION
Like any asset, homes fluctuate up and down in value (price)
in response to market conditions. A home purchaser faces the risk
that the value of that home will fall between the time of purchase
and the time of sale. To mitigate market risk, a buyer might want
to transfer the risk to an insurer through an insurance policy.
An insurance policy that insures a homeowner against loss
incurred on the basis of falling home prices is called a "Home
Price Insurance" policy. In consideration for a premium payment
or payments, an insurer agrees to reimburse the insured if home
prices in the area fall between the time the insurance policy goes
into affect and the time the house is sold (if the policy is in
In order to offer such a policy profitably to homeowners,
an insurance company must overcome the problems of "uniqueness".
Uniqueness means that each home is different and each seller's situation
is different. The uniqueness of each home makes its individual marketability
difficult to measure and predict. The value of an individual house
may not move in parallel with other homes in the same area. The
uniqueness of each seller's situation means that the final sales
price can differ drastically based on the homeowner's urgency to
move, flexibility in negotiations, etc. These factors are beyond
the influence of the insurer.
To overcome this problem, a home price insurance policy should
not rely upon the purchase and sale price of an individual home,
but on changes in an aggregate local property index during the duration
of ownership. Examples of such indexes are those maintained by S&P
Case-Shiller for ten major U.S. metropolitan areas.
To illustrate, imagine that a man purchases a home in Chicago,
Ill. for $300,000. He simultaneously purchases a five year home
price insurance policy. During the fifth year that the policy is
in effect, he sells his house. During the time that the man owns
the house, the Chicago housing price index has dropped by five percent.
The man could file a claim against the home price insurance policy
for $15,000 to recoup some or all of his actual losses.
BRIEF SUMMARY OF THE INVENTION
To be successful and remain solvent, an insurer must ensure
that its policies are priced appropriately and that its claims risk
is effectively managed. This invention provides a method for utilizing
put options on futures contracts to solve both of these problems
for home price insurance policies.
As with any insurance policy, the premium must be sufficient
to cover overhead expenses, pay future claims, and earn a profit.
The key unknown element is the amount and size of claims that will
be filed in the future. Since there is no way for an insurance company
to know where home prices will be in the future, the insurer does
not know what the number and size of claims will be at the time
the policy is issued, making it difficult to know how large the
premium that it charges must be. This invention provides a method
for determining the portion of a premium needed to cover future
claims based on the cost of the options on housing futures contracts
that are needed to hedge the risk.
Once any insurance policy is sold, an insurer must manage
its claims risk by employing means to reduce losses that result
from making claims payments. Insurance companies typically manage
this risk by accepting it, transferring it to another entity (reinsurance),
or hedging it (through financial derivatives). This invention provides
a method for solving this problem by hedging claims risk through
the use of put options on housing futures contracts.
BRIEF DESCRIPTION OF THE SEVERAL VIEWS OF THE DRAWING
FIG. 1 is a flow chart that depicts the process of using
the cost of put options on housing futures contracts to help determine
the premium an insurer should charge a customer for a home price
FIG. 2 is a flow chart that depicts the process an insurer
would utilize to hedge claims risk on a home price insurance policy
using put options on housing future contracts.
DETAILED DESCRIPTION OF THE INVENTION
To determine the premium that should be charged for a home
price insurance policy, an insurer needs to determine its overhead
in offering and servicing the policy, its desired profit margin,
and its claims liability. The premium charged should be an aggregate
of these items:
Overhead+Desired Profit+Claims Liability=Premium
Reserves are defined as the funds that an insurance company
sets aside to settle potential claims. Exposure is defined as the
losses that an insurer is likely to endure due to claims liability.
The greater an insurer's exposure, the higher the insurer's reserves
need to be to maintain solvency. The more money that an insurer
has tied up in reserves, the less money it has to invest, resulting
in lower profitability. So lowering exposure leads to lower premiums
and greater profitability.
To lower an insurer's exposure, a method of using options
on housing futures contracts to hedge claims risk is proposed. The
method is described as follows:
When a potential customer requests a rate quote for a home
price insurance policy, he or she specifies the coverage amount
(typically the value of the home), the maximum term of the policy,
and the metropolitan location of the property. For the purposes
of illustration, let us imagine that the customer is purchasing
a $300,000 home in the Chicago metropolitan area and wants coverage
for a term of five years.
The insurer then utilizes this information to price put options
on housing futures contracts with an aggregate size equal to that
of the coverage amount and a length equal to the maximum term of
the policy. Returning to our scenario, let us say that the S&P/Case-Shiller
Home Price Index for the Chicago metropolitan area is currently
at 200. The multiplier for housing futures contract offered by the
Chicago Mercantile Exchange is $250. The insurer would therefore
price six put options on housing futures contracts with strike prices
at today's prevailing market price ($250.times.200.times.6=$300,000)
and expiration dates 60 months into the future. For illustration
purposes, let's say that such options on futures contracts are currently
selling for $500 a piece. The insurer would therefore pay $3,000
for these options. Let's also imagine that the insurer estimates
that another $1,000 would be needed to cover all other overhead
expenses and provide an adequate profit margin. The insurer would
therefore offer the policy for a premium of $4,000.
The aforementioned process for using put options on housing
future contracts in the determination of home price insurance premiums
is depicted in FIG. 1.
Assuming that the homeowner purchases the home price insurance
policy, the insurer now needs to manage its claims risk. The proposed
method of doing this is for the insurance company to utilize the
premium payment to purchase put options on futures contracts with
the specifications used initially to price the policy. In the example,
the insurer would purchase six options on housing futures contracts
with an expiration date 60 months into the future for the Chicago
Metropolitan Area from the Chicago Mercantile Exchange for $3,000.
If the housing price index remains constant or rises during
the term of the policy (defined as the period between the purchase
of the policy and the sale of the home or the purchase of the policy
and its expiration), then the put options on futures contracts are
allowed to expire worthless. (The value of the options will be zero
and exercising them would result in the insurer purchasing housing
future contracts above their market value, creating losses).
If the housing price index falls during the term of the policy,
the put options on housing futures contracts are exercised or sold,
and the profits from the transaction are utilized to pay the insured's
claims. (The value of the options will be greater than zero and
exercising the options will result in the insurer purchasing housing
futures contracts below their market value, resulting in gains).
The aforementioned process for using put options on housing
futures contracts to manage the claims risk of an in-force home
price insurance policy is depicted in FIG. 2.
The embodiments of the invention in which an exclusive property
or privilege is claimed are defined as follows: