Former hurricane Ernesto reached Florida on Tuesday, just as we are about to enter the second, riskier half of the 2006 hurricane season. In 2005, insurers and reinsurers -- such as Hidden Gems pick Montpelier Re (NYSE:MRH) and Inside Value pick Endurance Specialty (NYSE:ENH) -- took the hurricane season on the chin, with a record aggregate insured loss of approximately $60 billion. After suffering a year that produced a record four Category 5 hurricanes, the industry was forced to reexamine its catastrophe loss models. However, insurers might be better off firing their statisticians, modelers, and climatologists, and spending more time tracking an online marketplace instead.

Last week, online derivatives market HedgeStreet launched contracts that allow retail investors to take a punt on the estimated damage amounts associated with individual hurricanes, as well as with the overall hurricane season. The contracts ("binaries") are available for different damage levels ($25 million, $100 million, and $1 billion for Ernesto, for example) and are structured on a winner-takes-all basis. If you purchase a contract with a strike price of $25 million and preliminary damage estimates exceed $25 million, you receive $100; if damage estimates are less than $25 million, you receive nothing. In this framework, contract prices reveal market expectations concerning the probability that damage estimates will exceed the threshold amount.

HedgeStreet is an example of a prediction market, the most famous of which is probably the Iowa Electronic Market, which allows participants to make real-money bets on the outcomes of political events, such as elections. There is a substantial body of evidence suggesting that prediction markets are more accurate in predicting actual outcomes than individual experts. Unfortunately, one of the areas in which prediction markets could be subject to the same bias as individuals is small-probability events -- precisely those events that are of greatest concern to catastrophe insurers.

Furthermore, prediction markets require a critical mass of activity to produce meaningful results. Trading volume in HedgeStreet's hurricane contracts is still low. The most active contract refers to damages during the entire hurricane season with a strike price of $25 billion; as of 8 p.m. EDT on Tuesday, the last trade price was $12, indicating that the market estimate of the probability that damages will exceed $25 billion is 12%.

Still, one can hope that volume will increase, adding weight to the prices being displayed. At the very least, HedgeStreet is a reminder that insurance and reinsurance companies (and by extension, their investors) are in the business of making educated bets on the likelihood of future events. As an investor, your job is to separate those firms that are charging their customers vigorish in the process from those that are giving it up.

Earnings Growth (Est. five years)

P/BV

Forward P/E

Endurance Specialty

12%

1.1 times

5.8 times

Montpelier Re

12%

1.5 times

5.8 times

Peer Group*

12.1%

1.3 times

6.6 times
* Based on closing prices on 08/28 for a peer group containing Allied World Assurance (NYSE:AWH), Arch Capital (NYSE:ACGL), Aspen Insurance (NYSE:AHL), Axis Capital (NYSE:AXS), Platinum Underwriters (NYSE:PTP), and Renaissance Re (NYSE:RNR). Average P/BV and P/E multiples are weighted by market capitalization. Average Earnings Growth rate is unweighted. Related Foolishness:

Fool contributor Alex Dumortier has a beneficial interest in Endurance Specialty, but none in any of the other companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.