ENTERPRISE RISK MANAGEMENT
By Michael J. Moody, MBA, ARM
One of the distinct advantages of enterprise risk management (ERM) is that it focuses on risk rather than insurability and then determines how to mitigate or eliminate risks that are considered significant enough. One of the first "uninsurable" risks to be dealt with through alternative financing mechanisms is weather. For years, companies believed that the adverse effects of weather were just one of the hazards about which nothing could be done. The adage attributed to Mark Twain (but actually penned by a colleague of Twain's--Charles Dudley Warner--in an editorial in The Hartford Courant) that "everybody talks about the weather, but nobody does anything about it" was accepted as gospel by corporate America. And, indeed, there is very little that can be done to change the weather, but companies are finding that it is possible to reduce or mitigate the adverse effects of "bad" weather.
Weather risk management
Initially, weather risk management began with the utilities industry. Several utilities began to purchase weather derivatives as part of their overall company risk management program.
The timing for introduction of these derivative products could not have been better. The industry was in the middle of deregulation, and energy companies were searching for ways to stabilize their earnings projections. Prior to deregulation, utilities were allowed to earn a fixed rate of return on their assets. If there was a loss one year, whether it was attributable to weather-related factors or other factors, the utility was allowed to raise rates the following year. For the most part, this cost-plus concept had served the industry well for hundreds of years, but deregulation was about to change that. Deregulation forced utilities to modify their business models from a focus on return on assets to shareholder value. Utilities could no longer afford to have their earnings subject to the vagaries of weather related factors. They had to find another way to handle this exposure.
Weather-related exposures present a core risk for utilities and as such have a significant impact on their overall financial results. In a survey of the nation's top 200 utility companies' annual reports, taken several years ago, over 80% indicated that weather was a major determinant of earnings performance. In fact, about 50% claimed that weather-related actions were responsible for poorer-than-expected performance. Several groups of forward-thinking individuals soon realized the extent of this exposure and began to develop a formal weather derivative market; and in September 1999, the Chicago Mercantile Exchange pioneered the buying and selling of the first exchange-traded derivates. This then provided a market where utilities could come and purchase hedges for the adverse effects of heat, cold, rain, snow, and wind. These were products that were directed at the non-catastrophic aspects of weather risks. They were designed to cover loss of profitability, not loss of property.
Initially the new weather products were based on the related risks caused specifically by variations in average temperatures over a defined future period of time. The basic trading vehicles were indexed to heating degree days (HDD), which measures the relative "coolness" of the weather in a specific geographic region for a given period of time. Based on data provided by the National Weather Service, statistics are obtained that calculate the number of days over 65 degrees, as well as the average of the days' high and low temperatures. These calculations then form the basis of determining the HDD. On the other side of the equation, the reverse is used to determine the cooling degree days (CDD).
Utilities were quick to see the value of weather derivates since weather was a major driver of their results. They could see that the financial protection afforded by a weather derivate could mitigate, to a large degree, earnings fluctuations by guaranteeing a minimum level of income. This, in turn, helped stabilize their financial projections and pleased their stockholders. Soon the concept was sweeping the industry, so much so that recent projections have shown that about 90% of the energy industry practices some form of weather risk management.
Industry observers also began to realize how many other industries had weather-related exposures. Current estimates show that about three-quarters of all businesses have such exposures. And the U.S. Department of Commerce goes so far as to state that weather impacts companies that contribute over $1 trillion of the gross domestic product. While the weather market continues to be dominated by the energy sector, demand is also growing in industries such as agriculture, retail, leisure, airlines and construction.
Other industry segments
One of the first non-utility companies to use weather derivatives was Canadian snowmobile manufacturer, Bombardier, Inc., Montreal. The company has used weather derivatives for the past two years to offer their snowmobile customers a $1,000 rebate in the event of low snowfall. This program is credited with a 38% increase in sales. In addition, due to the design of the incentive, most of the sales occur months earlier than normal, so the company receives its revenue in advance of traditional sales patterns. Should they have to make good on the $1,000 rebates, the money is provided from the proceeds of the weather derivate.
For years, farmers have been able to utilize the commodities futures market as a method of smoothing their earnings. They could purchase a futures contract that would assure them a profit. However, they had to have a product to sell since the use of commodity futures is predicated on their ability to bring a crop to market. This obviously did not protect them from severe weather that wiped out the crop. The use of weather derivatives in conjunction with commodities futures can provide significant bottom-line protection for farmers.
The entertainment industry has also had previous experience with weather-related products on a very limited basis. In the past, companies purchased specialty insurance products that would provide protection for such outdoor events as concerts or other productions; however, these were usually for very limited duration, typically one or two days. Currently a variety of entertainment organizations has begun using weather risk management products. These would include theme parks, ski resorts, sea resorts, and other tourist-related operations.
The construction industry also has begun to take note of the value of weather-related products. Contractors work under continuous pressure to complete projects on schedule and within budget to avoid claims at the end of the project. Adverse weather not only can delay construction, but can also impose costly charges and financial penalties. One of the contractor's biggest headaches is that the speed at which concrete chemically transforms from a liquid to a solid depends on the temperature ... heat speeds up the reaction and cold slows it down. Too much of either will greatly affect the quality of the pour. Additionally, excessive rainfall is becoming a key element in determining the profitability of large construction jobs. While heat and cold will impact the quality of the concrete, it is rain that will most likely delay the completion of a job. Contractors have found that by utilizing a weather risk management program, they can reduce or eliminate their cash flow fluctuations and, as a result, can become more aggressive in bidding on prospective jobs.
A number of other industries are also very dependent on the effects of weather. Among them are:
* Viticulturists whose grape production is a direct result of the weather during the growing season, as is the quality of the resulting vintage.
* Brewers who depend on beer sales which typically drop during cooler than normal summers.
* Governmental entities that are located in snow climates can spend significant amounts on additional snow removal and salt spreading in heavy snow years.
All of these operations lend themselves to a weather risk management program.
Derivates versus insurance
Capacity for weather risk management programs can be structured either as a derivative transaction or as an insurance/
reinsurance contract. Although the goal of mitigating risk is common to both derivates and insurance contracts, there are fundamental differences between the two alternatives. The primary difference is that derivates are index-based and require that some predetermined trigger be breached in order for a payment to be made. Insurance on the other hand, requires both an index measurement, and an actual, economic loss on the part of the insured.
Obviously insurance purchasing is a much more traditional method of handling risks. Insurance companies who carry an assigned rating by national rating organizations provide the coverage. And typically insurance purchases have a more favorable accounting and tax treatment. Purchases of insurance policies can, for the most part be undertaken without the approval of a company's board of directors. Purchases of derivative products usually require board approval.
Decisions regarding whether to purchase an insurance policy or a derivate product must be viewed individually and depend to a large extent on the specific weather risk management goals of the company. Regardless of the vehicle chosen, weather risk products can benefit many businesses across many industries. In theory, any strategy that can lower the volatility of earnings or cash flow should lead to a higher valuation, and lower cost of capital as well as a preferred status with credit rating agencies. Accordingly, despite the newness of the weather risk management concept, a bright future is anticipated for these alternatives.
This bright future, however, may face a temporary delay as there is currently a dark cloud hovering above. The Chapter 11 bankruptcy of energy giant Enron Corp. last December has many people concerned about the future of weather derivatives because Enron was a strong supporter and user of them. Enron often was pointed to as proof that a state-of-the-art weather risk management program can help assure success. It will be some time before we know whether this bankruptcy has had an impact on the weather risk management products market. However, it is generally believed that the market is bigger than just one company, although it is quite likely that the industry as a whole will face tighter regulations and increased scrutiny of outside interests.
Enterprise risk management
In the past, weather has been used as a convenient scapegoat for poor financial results; however, today lower revenues and volatile earnings that are caused by weather are typically viewed by investors as excuses--and not very good ones at that. The same is true for all areas of risks a corporation faces. Shareholders and other stakeholders are not willing to accept sagging earnings. Today we live in an environment that places considerable attention on earnings per share estimates. And as many a company has found out over the last few years, strong results from beneficial strategies are not typically rewarded to the same extent that poor results are punished.
Accordingly, it is imperative that corporations adopt an enterprise risk management (ERM) approach. Only by taking a holistic view of your firm will you be able to maintain earnings stability over time. The earnings continuity that comes from the implementation of an ERM program will allow a company to more effectively deploy its capital and will ultimately turn ERM into an affirmative program that drives shareholder value. At this stage, ERM can still be considered a competitive advantage. However, as this movement grows, those firms that fail to implement ERM in the near future could find themselves at a significant competitive disadvantage. *