The weather risk management market examined from the broker's perspective.
Questions are being raised regarding the impact of September 11 and the collapse of Enron on the weather risk management market:
The simple answer to these questions is that neither event will negatively impact the long-term viability of the weather risk management market. To date, the industry has achieved attractive returns on capital from weather products. Ultimately, the weather professionals from Enron will likely find new positions at other firms that either already have capital dedicated for products or are bringing new capacity into the market. One may argue that the dispersal of intellectual capital from a concentrated source such as Enron will strengthen the market and diversify it.
Nevertheless, the weather risk management market is at a crossroad. It needs to expand the scope of its products outside the traditional end-users, the utility industry. This will require intermediaries that can provide the correlation and statistical analysis to structure products that can be submitted to the weather markets. Until recently, the weather markets provided the data analysis and structural considerations to end-users under the premise of `caveat emptor'. Many potential purchasers of weather risk management products, such as retail, hospitality and manufacturing industries understand that customer demand is correlated to weather but do not have the internal resources to quantify weather risk exposures. An intermediary with the analytical skills fills the role as the purchaser's `trusted advisor'. The involvement of intermediaries or brokers will broaden the scope of weather products and expand the market accordingly. By outsourcing weather risk management responsibilities, an end-user will instantly obtain the necessary knowledge to address his weather risks.
This article examines the growing demand for weather risk management products, identifies the assorted market participants in the wake of Enron's collapse, describes many of the products available in today's marketplace, and advises companies on how to best evaluate the wide variety of alternatives available.
The first weather transactions were effected in response to utility deregulation. Natural gas deregulation shifted risk of financial loss to the shareholders of each utility, thus exposing the shareholders to fundamental business risks of utilities. One such risk is the effect of adverse weather on operating margins. For instance, a warmer than usual winter will lessen the need for consumers to heat their homes, thus decreasing natural gas consumption. In order to compete for capital effectively, utilities were forced to recognise the effects of weather on their financial performance, and mitigate these risks. Thus, the utilities began trading weather risks among one another. The birth of the weather market as we know it occurred when Koch Industries and Enron announced they had arranged a trade based on heating degree days in Milwaukee for the winter of 1997-1998.
Attractive returns on investment in weather risks have drawn in new sources of capital, including banks, insurance companies and hedge funds, which are looking for ways to diversify their own portfolios while increasing returns. At the same time, demand for weather risk management products has expanded through the energy sector and beyond. Corporate risk managers are increasingly examining traditionally `uninsurable' risks in a new light, and are demanding solutions. Yet in response to this demand surge, weather markets are attempting to broaden the variety of products available. Since 1997, the weather market has evolved into a mature sector with a wide variety of players and products. In spite of this evolution, the weather market has yet to achieve its full potential. Most products purchased today are temperature-based, reflecting the capacity provided by the secondary market that trades temperature-based derivative products.
A variety of weather risk management products are available for purchase, including derivatives, and weather bonds. Most transactions to date have been indexed to either heating degree days (HDDs) or cooling degree days (CDDs).
Weather derivatives have been around since the inception of the weather market. They are tied to a specific index and the payoff is based upon predetermined changes in the underlying index. They can be either exchange-traded or over the counter.
Energy trading firms offer OTC derivatives. These derivatives can be somewhat tailored to each client's specific needs. To a large extent, clients can define the weather event to be covered and select locations that are meaningful to them. Not every trading firm will have the ability to meet each client's needs, but the potential for flexibility is there.
Exchange-traded derivatives are currently offered by two exchanges: the Chicago Mercantile Exchange (CME) and the London International Futures and Options Exchange (LIFFE). Exchange-traded derivatives are only offering temperature-based contracts in a handful of cities. LIFFE began trading in December 2001, and CME began trading in 1999. Trading volume is low, so the exchanges cannot offer significant liquidity. In addition, the ability to readily access these markets requires a significant technological investment, as most companies currently seeking weather protection are not active traders on these exchanges.It is often overlooked that the world's insurers have periodically provided weather products for many years but recently several new entrants have enhanced their interest and offerings. Weather insurance is generally tied to a specific index and is indemnity based, so it will only pay when the insured client actually suffers an economic loss. Insurance tends to be better suited to offer catastrophic coverage and multi-year deals than derivatives. The list of key players from the insurance industry is described in the next section of this article.
Another weather risk management solution is the issuance of weather bonds. To date, only one weather bond transaction has been executed, but the concept remains viable. Basically, weather bonds act as insurance. The company wishing to transfer its weather exposure enters a transaction where a bond is issued to investors. If a predefined unfavourable weather event occurs, the issuer can use the bond proceeds to cover its weather losses. Investors in the bond can be capital markets or insurance markets. They invest to achieve diversity and an attractive rate of return when likened to comparably rated asset classes. Structuring and placing a weather bond is time consuming and labour intensive; thus, they are better for large weather exposures.
As demand for weather risk management products grows, weather products will adapt to meet the demand. Markets already seem willing to expand protection beyond HDDs and CDDs to critical temperature days, precipitation, snow days, wind and stream flow. As companies identify and quantify their weather exposure, they will express a greater interest in dual-trigger or contingent weather structures. As several companies within an industry begin to purchase weather protection, the markets will respond by creating a product specifically tailored for that industry.
Since the inception of the weather risk management market, the number and type of market participants have continually expanded. A variety of market participants offer weather risk management products, including integrated energy trading firms, insurance companies, hedge funds, commercial banks, online trading platforms, and exchange markets. Each market has its own product line and pricing models. Some markets want to provide catastrophic protection while others relish playing in the higher-risk (and hence higher premium) layers. Despite their varying methodologies and philosophies, all of these markets have done their homework, and none can be considered naïve. They all have one thing in common: they will only provide protection against a clearly defined event that is measured by an objective standard.
Because the market originated in response to the needs of utility companies, energy trading firms were a logical market participant. Utilities had existing relationships with these firms, which helped utilities manage their exposure to natural gas prices. Already skilled in risk management techniques, energy trading firms were the initial weather market innovators, and remain major players in the market today. The most dominant include Hetco, Entergy-Koch Trading, Aquila and Enron, prior to its demise.
Energy trading firms offer OTC weather derivatives. End-users can obtain protection against specific adverse weather events and at locations that are meaningful to their operations. Protection is usually close to the risk, indicating a higher likelihood of coverage being triggered.
Insurance and reinsurance companies are increasingly active in the weather market. They can offer flexible coverage suited to each customer's need. Coverage is provided in either insurance or derivative form. Many companies prefer the insurance form with which they are familiar and accustomed to purchasing. Insurance and reinsurance companies typically prefer to provide coverage further from the risk. This does not mean that coverage is entirely catastrophic, but there is a lower degree of risk. Key players from the insurance side include: Element Re, a division of XL Capital; AXA; Kemper; Tempest Re, a division of ACE; St Paul; and Commercial Risk. If additional risks are added to the weather risk, this list expands to include AIG, Winterthur and most of the alternative risk market.
Banks and investment banks are also becoming active players in the weather market. Some merely provide structuring advice and help with placements, while others are actually risk takers. Like energy trading firms, they typically deal in derivatives and prefer a risk that's close to the money. They assume a higher degree of risk in hopes for higher returns. Many banks have extensive experience in financial trading and can use their existing client base to cross sell to clients seeking protection against their weather exposures. Some of the larger bank/investment bank players in the weather market are Goldman Sachs, ABN Amro and Deutsche Bank.
A handful of hedge funds are also involved in weather transactions. Bank funds like Société Générale, and Banque de Reescompte et de Placement (Barep) are notable. These funds may be interested in either high risks that offer higher returns or in more catastrophic risk layers that provide diversification with an uncorrelated asset class.
As noted, two exchanges offer weather derivatives - CME and LIFFE - but few contracts are available, and those on offer are certainly not flexible. However, exchange-traded markets do provide some pricing transparency and liquidity to the secondary trading market.
September 11 and the collapse of Enron are likely to shake things up in the weather market. It is unclear what the long-term repercussions of these events will be on the markets, but several scenarios are possible.
In the short-term, September 11 is likely to prevent the attraction of additional insurance capital to the weather market. The recession and hardening markets are causing companies to focus on their core business. Enron's collapse creates additional uncertainty. Enron invested significant resources to be a market maker. It was the largest provider of capacity in the secondary market. There now exists a significant void in terms of resources invested to create new and better solutions. Who will now step up to the plate?
In the long-term, the talent from Enron will not disappear. In some form or fashion, those individuals will find a home in the weather market, either as a team with a new source of capital, or as added talent to an existing market.
On another front, the convergence between the financial markets and insurance markets post-Gramm-Leach-Bliley is encouraging both markets to expand their product offerings, leverage existing client relationships and capitalise on arbitrage opportunities. Depending on management's goal as to the degree of convergence to be achieved at a particular company, markets may be looking for cross-over lines of business that allow them to use existing talent and resources to branch out into a new line of business.
So, neither event should negatively impact the long-term viability of the weather risk management market.
The recognition and management of weather risks spread through the energy sector to electricity and natural gas utilities. The bulk of the demand for weather risk management products still stems from the energy sector, but other industries are starting to take note.
`Enterprise risk management', a corporate buzzword, represents the process of managing risk at an enterprise-wide level, rather than at a divisional level. The idea is that a corporation may have naturally offsetting risks between two divisions or may have a large risk that is not managed because it is not significant at any divisional level. As companies increasingly examine their risks on an enterprise-wide level, they are finding that weather risk greater risk than previously thought, and they are looking for methods of managing that risk. Industries outside the energy sector frequently carrying unmanaged weather risks include construction, agriculture, outdoor entertainment, food and beverage sales, hospitality, manufacturing, transportation, government maintenance and retail.
Many companies in these industries are examining the effects of weather risk for the first time. Frequently, the effects are difficult to identify and quantify. For instance, a fertilizer manufacturer may not have fully studied the effect of rainfall on its product sales or a residential contractor may not have quantified the risks of extreme temperatures and how they affect concrete and masonry work.
At the same time that more companies and more industries are demanding weather risk management tools, they are also becoming more specific with their demands. End-users want customised solutions that exactly meet their needs. Some end-users are comfortable with the derivative structure; others would prefer a product with simpler, less cumbersome accounting treatment. In the atmosphere of recession, and in the wake of Enron's collapse, companies are increasingly concerned with the credit quality of their counterparties. Many clients are looking for multi-year deals that offer long-term stability with a highly-rated counterparty. Others are happy with shorter-term seasonal transactions. More and more end-users are looking for a combined insurance program that efficiently transfers weather risk. End- users' ability to access flexible solutions will drive growth in the marketplace.
In addition to growth in end-user demand, there is also a supply push being generated from the weather risk management markets. These suppliers assume weather risk for their clients and then look for ways to manage their own portfolio of weather risks. This supply push or `secondary' demand adds liquidity to the marketplace, but also adds to the cost. The reason is twofold: the original counterparty will add the cost of its own risk transfer into the cost to the end-user; and increasing demand in the secondary market allows secondary providers to raise the price of their products.
Each product is priced based on its own unique risk characteristics, and each supplier has its own method of pricing and the process is not by any stretch transparent to the end user. The derivatives market is not sufficiently liquid to provide transparency, and market prices can fluctuate greatly, even within one day. Although several online platforms have been created to increase price transparency, including Aquila's GuaranteedWeather.com and Swiss Re's ELRiX, price information is still not readily available. These and other platforms provide single-provider quotes for smaller weather derivative transactions. Pricing information is not readily available for larger, structured transactions or insurance products.
The price of traditional insurance is typically based upon an actuarial analysis derived significantly from historical results, while liquid derivatives, which derive their value on that of an underlying asset, utilise market-based pricing. But weather insurance is not traditional insurance, and weather derivatives are not liquid derivatives whose value can be adjusted based upon that of an underlying asset. Thus, it would be folly to solely utilise either the actuarial pricing method or a market-based pricing method to price a weather product. Consequently, both weather insurance and weather derivatives will be priced based upon some mix of the two methods. While historical data is invaluable, weather forecasts and hedging costs must be considered. Just as traditional insurance costs are affected by the primary carrier's reinsurance treaties, weather products are affected by the costs of laying off the risk to other markets, whether in insurance or derivative form.
Weather bonds may be issued to either insurance companies or other capital markets investors. The ultimate purchaser of the bonds will drive the analysis used to price the bonds. As with other weather products, the resulting price is also likely to be a combination of actuarial and market-based pricing.
Though end-users are calling for increased product flexibility and customisation, this feature creates added pricing intricacies. Different markets will offer different custom features, and a price comparison between two quotes will not be an `apples-to-apples' comparison. Add to that the form of the product and the credit quality of the supplier, and pricing comparisons become very complex indeed.
Credit concerns are an increasing issue with end-users, and as the events of September 11 have shown, much of this concern is well founded. As recent as summer 2001, few end-users expressed concern with Enron and its S&P BBB+ rating as a counterparty. Insurance companies offered credit enhancement products for Enron counterparties, but these instruments had virtually no value to end users, who were unwilling to pay even nominal amounts for such protection. Since the demise of Enron, analysts are increasingly focused on the credit quality of energy trading firms, and several have been downgraded, some to junk status. Those that have not yet been downgraded have capital restructuring plans underway and an increased focus on their financial statement stability. The days of comparable pricing between S&P AA rated companies and S&P BBB rated companies are over. The more highly rated firms will begin charging for their balance sheet accordingly.
As financial analysts increasingly stress credit quality, end-users are increasingly aware of the need for and cost implications of transacting with a counterparty of a higher credit rating. There are essentially two methods of obtaining what amounts to a credit enhancement: transact with a higher-rated counterparty which is a risk-taker, or use a higher-rated counterparty to enhance the credit rating of another ultimate risk-taker. There should not be a significant pricing differential between the two methods. In order to obtain and retain a higher credit rating, suppliers must maintain certain minimum capital requirements. The cost of not being able to use this capital in a productive way is built into the cost of each product offered by the supplier. This is the case whether or not the supplier is the ultimate risk-taker.
By outsourcing weather risk management to an intermediary, end-users will have expert assistance to help sort through all the confusion. Intermediaries include weather brokers, insurance brokers and some banks. The ideal outsourcing group is one which owes a fiduciary duty to the client to identify and analyse the appropriate product, supplier and price. It should be able to assist the client in identifying and quantifying weather exposure, and from that, to create and implement a structure solution that will manage, mitigate or transfer the risk.
TFS and United Weather are dominant weather derivative brokers. They provide an independent point of contact for two parties to negotiate a mutually agreeable transaction on anonymous terms. Both have expressed a willingness to help end-users identify and quantify their weather exposures, and to assist in structuring larger structured transactions. But weather derivative brokers are just that. Without meeting additional regulatory requirements, they cannot offer weather insurance or weather bonds. Therefore, they are not ideally suited for outsourcing of these services.
Banks may also offer brokering services. But some banks will have an inherent conflict of interest in that they also assume risk and supply weather products. Clients should be aware of this potential conflict. Most banks will also only have access to the derivative and capital markets. Accessing insurance markets requires regulatory approval and licensing, which many banks do not have.
From a theoretical perspective, insurance brokers have distribution and the risk management systems which place them in the best position to act as an impartial intermediary for weather products. However, few insurance brokers have invested in the development of people and systems to reflect a commitment to the weather risk management market. Brokers like Aon that have made such a commitment have access to all suppliers and products and can act as an independent third party, recommending the coverage best suited to their clients' needs. Additionally, insurance brokers are familiar with their clients' risks and can better help them analyse and quantify their weather risk in the context of their broader risk management strategies. Most importantly, since insurance brokers are not a counterparty in a transaction, they do not have a financial conflict of interest in the structuring and placement of a weather program. Insurance brokers are in contact with markets on a regular basis and are able to understand the specific preferences of many markets with respect to building and diversifying a market portfolio of weather risks. They are the ideal candidates for an end-user to outsource weather risk management.
The process used by a broker in executing a weather risk management transaction should include the following steps:
Two items are especially important to note about this process. It is critical that conversations with markets are held in strict confidence. Once it is publicised that a specific client is interested in a particular weather transaction, market participants begin trading in anticipation of the actual placement.
This tends to drive up the costs of transaction. Another cost factor is the proper disaggregation of risk. As noted above, some markets are more comfortable retaining higher levels of risk than other markets. If a market is asked to retain a higher degree of risk, or conversely, to participate in layers without a higher return potential, they will price the risk less favourably than a market more interested in that particular risk layer. For example, if a customer wants to purchase a car from a car dealer, but wants the car dealer to regularly wash the car as well, the dealer is likely to charge a premium for washing the car, since that is not the main source of revenue for the dealer. In order to get the best price for its clients, an intermediary should provide a focused effort in syndicating the risk.
Selecting an intermediary
Characteristics to consider when selecting an intermediary to represent your firm to the weather risk management markets are as follows:
Look for inherent conflict of interests such as the possible financial interest the intermediary may assume in the transaction as a counterparty or risk-taker.
Can the intermediary control the marketing process and represent your firm to the weather risk management market on an anonymous basis?
Remember that the weather market is still relatively small and the secondary market may speculate on taking positions for arbitrage profits if the market knows that your firm is actively seeking weather risk protection.
Some of these issues may appear self- evident, but it is our experience that the best results are the product of a controlled marketing effort.
In spite of the events of September 11 and Enron's demise, the weather market will continue to expand in response to increasing end-user demand. This expansion will further encourage the increasing complexities of product features and pricing mechanisms. End-users will have an increasingly greater challenge in evaluating their options.
By enlisting the services of a trusted advisor, an end-user can have price transparency and maximum market leverage. The value of intermediaries will be immeasurable going forward as the weather risk management market continues to expand and diversify.
By Dan Sloan, Liz Palmer and Holden Burrow
Dan Sloan is executive vice president and Liz Palmer and Holden Burrow are directors of Aon Natural Resources Group, working in the Risk Capital Products department. The authors may be contacted at the company headquarters in Houston on +1 713-430-6790 or via email at firstname.lastname@example.org