David Scott describes the creation of the first UK weather insurance/derivative product.
The placement of the first weather insurance for a UK exposure based on derivative concepts was not a simple matter. The client's request for a weather derivative contract to protect it against low revenue during the winter had been broadcast to the market in October 1998. Over the following months, there was a variety of quotations using multiple weather stations, different trigger points, designed as options, swaps, retrospective insurances, profit sharing insurances etc.
These failed because of their initial complexity and lack of clarity in the central technical issues. It was only when the product was redesigned to keep it simple, that we were able to succeed.
First came the data. Obtaining data was not the problem; Paul Miller in Aon catastrophe risks was already highly knowledgeable on UK weather with good contacts with the Meteorological Office. The important thing was understanding what the data actually represented. The Heathrow weather station was selected as key, since everyone knew where it was and it was, therefore, unambiguous, while “London” could be represented by a number of stations. From the data it was clear that there was a very high correlation between all UK weather stations.
Cleaning the data took some time. What did the maximum and minimum represent? How was the data collected and was this consistent during the past and for the future? Why did there appear to be inconsistencies when temperatures were being reported daily? How did the data differ from those published internationally? Solving these problems was critical to getting the market to accept Heathrow as the base line for the product.
Analysing the data and designing the product was key. It had to be attractive to the client and the market. Statistical analysis provided some of the results but what about the longer-term trends? Were there cycles in weather patterns? Did a warm October increase the likelihood of a warm winter?
We used the US concept of heating degree-days (HDDs) converting this to a centigrade scale measuring from 18 degrees. In other words, if the average of the minimum and maximum is 7 degrees Centigrade during a winter day, there are 11 HDDs (18 minus 7). Eighteen degrees was chosen as being close to the American standard of 65 degrees Fahrenheit, since we wanted the American market to participate and feel comfortable with the contract.
The numbers of HDDs were totalled for the five month winter period. We chose a rate on line of 10% and designed the product around that. To do this we selected a series of attachment points (triggers) that gradually increased the amount of protection for the client. In this way the client retained substantial risk. The initial trigger would come into play during a moderately mild winter while a full limits payment would only occur if the weather was excessively mild.Design of the contract was another issue. A transformer was needed to ensure all international markets could participate on an equal footing. As I was registered in both the securities and the insurance markets, I was able to turn to professionals in both. This all took time; however, the client did not give us the firm order until two days before Christmas! Everyone swung into action. The brokers covered the market. I gave endless presentations. We used our American colleagues. We batted data, analysis and contracts across the internet. We did this during one of the warmest new years on record. We closed the deal during the first week of the new year.
The lessons for insurance and for ART
Concepts developed in other financial markets can be used in the insurance market, although there are differences in contracts, thinking, and willingness to participate. The financial markets typically like simple, relatively straightforward risks for which there are natural counterparties and can be easily traded. They prefer risks close to the average. The insurance market is happier with complex, one-sided extreme risks with no counterparties.
The insurance market can not compete directly with the derivatives market. However, it does not need to. The value of the insurance industry is precisely in insuring those risks for which the derivatives market place is less suited. It can use a derivative as part of the design. It must achieve a status as the financial instrument and market of choice for those risks for which it chooses to compete. It must also improve its efficiency and learn from other markets. Finally to students of ART insurance products - understand what the client wants, understand the risk and keep it simple.
David Scott, a strategy director with Aon Group, is currently on sabbatical completing an MBA (Finance) at City University (London).