Weather risk management Growth in derivatives continues to soar By Michael J. Moody, MBA, ARM When some agents and brokers think of weather risk management, they immediately think about some type of special events coverage that can be written to cover a rainout of a charity golf outing or some other single-day event that takes place outdoors. And while these types of special event coverage are quite popular, they represent just the tip of the iceberg that has become weather risk management. Over the past 10 years, weather risk management has become big business and the prospects for future growth are enormous. Slow start Weather-related insurance products have been available in the general insurance market for years. However, it was the involvement of the capital markets that sparked a renewed interest in weather risk management products. The capital market products, known as weather derivatives, are a relative newcomer to the risk management community and are, for the most part, an outgrowth of the deregulation of the energy industry that occurred in the mid-1990s. Prior to deregulation, utility companies were regulated as monopolies, and many of them utilized what was known as “weather normalization adjustments” to recover the additional costs and/or lower profits caused by unseasonable weather. These adjustments allowed the utility companies to pass these unexpected costs directly to the ratepayer, thus allowing the utility company to avoid both the costs and risks associated with any unpredict-able aspect of their business. However, this changed dramatically once deregulation occurred. With deregulation, the utilities needed to learn how to play by new rules. And, as they soon found out, their shareholders were no longer satisfied to hear how the adverse effects of the weather had eroded their company’s profits. The energy industry needed to find an acceptable alternative for this issue. As a result, several large energy companies began to explore methods to tap into the capital markets to find ways to offset this unacceptable risk. What they developed were weather derivatives, which are hedging instruments that help utilities offset sub-par results due to the vagaries of the weather. Initially, weather derivatives began as over-the-counter (OTC) trades. OTC derivatives were privately negotiated, individualized agreements made between two parties, which greatly limited their attractiveness as an investment vehicle. However, in 1999 the Chicago Mercantile Exchange (CME) became actively involved in the weather derivatives market. Today, CME offers weather futures and weather options on futures. Both are standardized contracts, which are publicly traded on the open market in an electronic auction-like environment. This allows for greater liquidity, continuously negotiated prices and complete price transparency. The market has greatly expanded since being introduced in 1999, when there where only a few derivatives available for a handful of U.S. cities. Currently, derivatives are available for 18 U.S. cities, nine European cities, and two cities in Japan. Similar but different One of the most confusing parts of weather risk management is the difference between weather insurance and weather derivatives. For the casual observer, the differences can be difficult to see, since the products have many similarities. Both are designed to provide protection and to mitigate the adverse financial effects of weather. However, in essence, weather insurance is designed to cover high-risk, low-probability events such as hurricanes, heavy snowfall, hailstorms, and rainouts causing cancellation for outdoor events. In sharp contrast, weather derivatives protect against lower risk, higher probability events, such as cooler summers or warmer winters. Weather derivatives are basically temperature-based index futures and options that are geared to seasonal and monthly weather conditions at various locations worldwide. The derivatives quantify weather in terms of degrees above or below monthly or seasonal average temperatures and attach a dollar amount to the number of degrees the temperature deviates from the average values. The key that makes this whole process work is that it is based on a specific index that has been agreed to by all participants in advance. Weather contracts for the winter months are classified according to an index of Heating Degree Day (HDD) values, days in which energy is used for heating. Summer months are geared to an index of Cooling Degree Day (CDD) values, in which energy is used for air conditioning. Both HDD and CDD values are calculated according to how many degrees an average daily temperature varies from a baseline of 65 degrees Fahrenheit. Quantifying weather in this way makes it possible to trade weather in a way that is comparable to trading varying values of stock indexes, currencies, interest rates, or even agricultural commodities. Administratively, there are three critical areas of difference between weather insurance and weather derivatives: • Accounting and tax treatment Typically, weather insurance products pay based on actual damages sustained by the insured. This is in contrast to a derivatives product, which pays based on the difference between a negotiated weather-related index and the actual weather. For the most part, with regard to weather insurance, the insured must prove they actually suffered a financial loss that was covered by the insurance policy. However, the derivative pays an amount based on a triggering event regardless of whether the derivative holder suffered a loss or not. Each of the weather risk management techniques—weather insurance and weather derivatives—fills a specific need, and frequently a company will require both. Increasing importance This past year’s hurricane season is a ready reminder of the significance of weather-related risks. Last year’s storm season’s numbers are impressive by any standards: • A record number of named tropical storms (27) Couple this with the fact that as much as 20% to 25% of the U.S. economy is directly affected by weather, and one can easily see the magnitude of the problem. Further, it’s not just an energy or utility industry problem. The profitability and revenues of virtually every industry: agriculture, construction, entertainment, travel, etc., depend to a certain extent on the effect of weather. Former Commerce Secretary William Daley has indicated that, “Weather is not just an environmental issue; it is a major economic factor. At least $1 trillion of our economy is weather sensitive.” The weather insurance market continues to gain interest yearly as the adverse effects of weather continue to take a toll on the financial results of businesses worldwide. But it has been the interest in the capital markets that has caused the most attention. The Weather Risk Management Association, the international trade organization of the weather risk management industry, recently announced that the value of derivative contracts for the period of April 2004 to March 2005 was $8.4 billion. According to the association, this represented an 83% increase over the previous year and was an all-time high for the industry. Even more impressive is the growth that has occurred at the CME. The 2004 totals traded at the CME were $2.2 billion, but they grew to more than $35 billion in 2005. These figures not only reflect the interest by weather-prone industries, but also a growing interest by hedge funds which are now actively trading CME weather contracts due to the transparency and liquidity of the market. Opportunity knocks A comprehensive weather risk management program can assist a large number of industry segments, and it can mean the difference between profit and loss for many organizations. And with the continued pressure of weather-related events having adverse financial effects on many organizations, more and more organizations will be attracted to weather risk management products. This can result in a very favorable environment for many mid-sized agents and brokers and may offer an excellent opportunity for them to move into the alternative risk transfer (ART) market. While it may be difficult for some agents and brokers to take advantage of the ART market with regard to captive insurance companies or even self-insurance, weather risk management may be the ideal vehicle to gain an ART market segment. Weather risk management can provide an easier road to the ART market and can provide a great value-added service to the agency’s current customers. Additionally, since weather risk management is still in its infancy, many new prospects can also be found. Developing an expertise in weather risk management could be a boon to business development, while allowing an agency to establish a center of excellence in a rapidly growing part of the risk management community. * |
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