As the weather risk market grows and end-users become increasingly aware of the various risk management opportunities available, they need to focus on the different financial and legal issues that characterise insurance and derivatives by Erik Banks.
The weather risk management market, which seeks to protect companies against the economic impact of catastrophic weather (low probability/high payout events) and non-catastrophic weather (high probability/low payout events), lends itself to risk management solutions that incorporate concepts, expertise and capital from the insurance, reinsurance, derivative and capital markets. Risk protection can be written on a variety of non-catastrophic weather events, including temperature, humidity, rainfall, snowfall, streamflow,1 and wind. Protection can also be written on catastrophic weather events, including hurricanes, tornadoes and windstorms. Our focus in this article is limited to the non-catastrophic weather market.
The non-catastrophic weather risk management market is one of the newest and most dynamic sectors of the financial risk transfer arena and includes participants from a broad range of global industries. Risk providers - those writing risk protection or supplying risk capacity - include re/insurance companies, commercial/investment banks, energy companies and institutional investors. Many of these players are eager to expand their product/service offerings, build new client relationships, transfer or reshape risk profiles, reallocate capital in support of higher margin businesses, enhance balance sheet strength and liquidity, capitalise on favourable arbitrage opportunities, optimise legal, tax and financial positions or invest in new asset classes. These institutions supply the technical knowledge and/or underlying risk capacity needed to promote activity. Re/insurance companies, which have provided risk coverage for catastrophic weather for many decades, have started offering risk coverage for `closer-to-the-mean' non-catastrophic weather risks.
Commercial and investment banks - capable managers of risk in traditional financial asset classes including equities, currencies and interest rates - have begun to extend their risk management and structuring skills to markets such as weather - primarily through derivative and capital market products rather than conventional insurance solutions. Energy companies, with considerable exposure to non-catastrophic weather (primarily temperature), are active providers of risk capacity and solutions.2 Other institutional investors - including hedge funds and pension funds - supply investment capital in expectation of superior economic gains generated by new risk transfer products (e.g. a weather bond).
End-users - those looking to hedge their non-catastrophic weather risk exposures - include companies from a wide range of industries, including energy, agriculture, transportation, construction and recreation/entertainment. End-users seek to manage specific weather exposures through customised weather risk protection products. For instance, an agricultural cooperative may fear the impact of a sustained heatwave on crop yield, and might seek to protect against economic loss caused by high temperatures during the summer. A ski resort, dependent on snow for its revenues, might seek to protect against a lack of precipitation and/or overly warm temperatures during the prime ski season. State and municipal governments might wish to protect their budgets from losses created by excessive snow clearing operations.
Though the weather risk market is still largely US-based, new international participants from Europe and Asia have arranged significant overseas transactions in the past year and further global expansion is anticipated. According to a 2001 survey conducted by PricewaterhouseCoopers on behalf of the Weather Risk Management Association, over $7.5bn of weather risk has been transferred since 1997 - representing growth of over 3000% in just four years.3 As companies from different economic sectors and industries gain an understanding of the economic impact weather risk can have on their financial operations, activity is likely to expand even further.
As noted, weather risk management tools exist to protect against the effects of non-catastrophic weather events based on temperature, rainfall, snowfall, humidity, streamflow and wind. Once a weather risk exposure has been identified and quantified, virtually any type of risk solution can be created to provide a company with the desired level of financial protection; this most often involves the use of instruments such as derivatives and insurance. Risk providers are increasingly able to offer end-users and investors (as well as each other) a wide variety of products, structures and mechanisms to manage weather risk exposures or create investment opportunities. For instance, a company seeking to protect against lost revenues from a cool summer can purchase a cooling degree day (CDD)4 put option or a CDD insurance policy, or sell a futures contract on the Chicago Mercantile Exchange, the London International Financial Futures Exchange or one of the new online exchanges (e.g. Intercontinental Exchange). More complex weather risk products and strategies, such as collars (long/short options) and swaps, can also be used.
In most cases it is mechanically straightforward to package a risk exposure that has been identified and quantified into a form that most readily suits a client's requirements. If a company has a history of purchasing insurance to cover its weather risk exposures, and has geared its accounting, tax and legal operations accordingly, it is generally simple to provide weather protection in the form of a standard insurance contract. The provider supplying such protection must, of course, be capable of offering insurance and approved to do so. Insurance-related protection therefore tends to be written by insurance companies rather than non-insurance players. Conversely, if a company is comfortable dealing with derivatives and is prepared to adhere to relevant derivative accounting and legal rules, it may wish to execute weather protection in the form of a derivative. This, again, requires the provider to be authorised to offer derivative contracts; financial institutions and energy companies, as well as the financial subsidiaries of insurance companies, are the obvious providers in this case.
In certain instances integrated operations or joint ventures can provide weather protection in either insurance or derivative form. This is certainly a competitive advantage, though one which is difficult, and often expensive, to create; the legal, regulatory and accounting costs associated with the formation of multi-product vehicles can act as a barrier. It is worth noting that insurers, rather than end-users, bear the burden of meeting the requirements imposed by regulators when creating a weather insurance policy while end-users, rather than providers, bear the burden of meeting the requirements imposed by standard derivatives documentation (as discussed at greater length below).
Much of the activity in the weather risk market over the past four years has been centred on over-the-counter (OTC) derivatives (including swaps, puts, calls, and collars). However, more recently numerous corporate end-users have chosen to examine weather insurance policies, and a growing number of transactions are appearing in insurance form. For instance, in 2001 US energy firm Atmos Energy executed a multi-year weather cover in the form of an insurance policy. As the market grows and end-users become more aware of the different opportunities available to actively manage their weather risks, they need to focus on the different tax, accounting, legal (documentation/bankruptcy) and credit issues that characterise insurance and derivatives - this can help them select the optimal type of cover.
Tax and accounting issues
Weather protection written as insurance can provide end-users with certain tax benefits. In general, premiums and losses under insurance contracts are taxed as ordinary income, while those under derivative contracts may be taxed either as ordinary income or, more frequently, as capital gains/losses. Ordinary income treatment may be preferable to capital gains/losses as capital losses are only deductible if capital gains exist. More specifically, upfront premium paid to secure a weather insurance contract is typically treated as ordinary income and is immediately deductible for tax purposes. Under a derivative contract, the same premium is often treated as capital income and is not immediately deductible. It is important to note that advantages related to insurance premium deductibility may be offset by the existence of an insurance premium tax, which varies by state and country.
Fair value changes in a weather insurance contract (due to actual weather changes and changes in the forward curve) need not be recognised, while fair value changes in a weather derivative contract are regarded as capital income and must be marked-to-market through the earnings account. Actual losses incurred through an insurance contract are treated as ordinary losses and recognised through earnings, while losses through a derivative contract are considered capital losses and marked-to-market through earnings.
In addition to tax reporting differences, weather insurance and derivative contracts attract different accounting treatment under US Generally Accepted Accounting Principles (GAAP).5 For instance, upfront premium payments under an insurance contract are immediately expensed through the `other expenses' line item, while payments under a derivative are capitalised on the balance sheet as an asset. Changes in the fair value of a weather insurance contract need not be recognised from a reporting perspective, while those impacting a derivative contract must be recognised in the current period through the `unrealised gains/losses' line item. Actual losses incurred under an insurance contract that are measurable or estimable are accrued under the `other income' line item, while those incurred under a derivative are recognised in the current period through the `investment income' line item.
Considerable differences exist between weather derivatives and weather insurance. While a weather derivative is excluded from the regulatory scope of the Commodity Exchange Act (CEA), as amended by the Commodity Futures Modernisation Act, a weather insurance policy, like all other insurance products, is highly regulated and must adhere to the regulatory parameters established by state and national authorities. A weather derivative protects against the risk of adverse weather movements regardless of whether the company entering into the transaction actually incurs a loss. A company with a derivative receives payment if the weather event described under the confirmation is shown to have occurred at the relevant monitoring station.
By way of comparison, an insured must demonstrate and prove that it incurred the loss specifically delineated under the policy. In order to receive payments under the policy, the insured must suffer an actual loss that is related to the underlying weather condition. For instance, in early 2000 the Office of the General Counsel for the New York Insurance Department indicated that weather derivatives do not constitute insurance. Specifically, the General Counsel stated that since "the issuer is obligated to pay the purchaser whether or not that purchaser suffers a loss" and since "[n]either the amount of the payment nor the trigger itself in the weather derivative bears a relationship to the purchaser's loss," weather derivatives are not insurance contracts under Section 1101(a) of the New York Insurance Law.
This opinion highlights the notion of `insurable interest' - a key difference between weather derivatives and insurance. While each state law defines the concept of insurable interest (or insurable risk) differently, one definition indicates that it is an "interest as will make the loss of the property of pecuniary damage to the insured." An entity executing a weather derivative does not need to show an insurable interest in property or even be adversely impacted by fluctuations in weather. An entity wishing to provide weather insurance as a weather risk mitigation product must first draft a form of insurance policy which meets the definition of `insurance' under the state law where the policy is to be written. Once a weather insurer has drafted the policy, it can be written on an admitted basis (with rates and forms filed with the relevant state insurance department) or surplus lines basis (with no specific submission of rates and forms to the state insurance department). Since state, rather than federal, law governs US insurance companies, the insolvency laws of the state (rather than the Federal Bankruptcy Code) are applicable in the event an insurance company providing a weather insurance product to an insured files for bankruptcy.
Generally, the insolvency laws of the state of domicile of the insurance company apply; however, determination of which state law(s) apply may be complicated by the number of states in which an insurance company is actually admitted. In the event of the bankruptcy of an insurance company, the state may exercise one of three options, including supervision, receivership/ rehabilitation, or liquidation. In the event that an insurer is liquidated, the order in which expenses, creditors and policyholders of the insurer are paid is subject to the applicable insolvency priority statutes for that state. Depending on the nature or severity of the insolvency, a state may also use its guaranty fund. Unlike the favourable Federal `safe harbour' treatment provided to a weather derivatives counterparty which is exposed to an insolvent counterparty (discussed in further detail below), the treatment of the weather insured is based on the particular bankruptcy protections provided under the applicable state law.
Since weather derivatives are similar in form to other financial derivatives, most foreign and US companies use the 1992 version of the Multicurrency, Cross-Border International Swap Dealers Association (ISDA) Master Agreement to document their weather derivative trades. Because the printed ISDA Master Agreement was amended in 1992 to provide general terms and conditions for various types of OTC derivative transactions, weather derivative participants have been able to utilise the agreement structure as the master terms and conditions underlying their trade confirmations.
In addition to addressing many of the issues found in any legal contract - such as representations, assignment, payment, governing law, notices, expenses, and so on - the printed form provides default and termination provisions and close-out netting and liquidation rights in the event of a bankruptcy termination. These provisions provide considerable benefits to providers or end-users that have multiple weather risk derivative positions with a single counterparty. Under the US Bankruptcy Code, upon the bankruptcy or insolvency of a party to a contract, the non-bankrupt party is prevented from terminating its contract with the bankrupt party and is subject to the automatic stay provisions of the Code. There are, however, certain bankruptcy exceptions for `swap agreements' entered into by `swap participants.'6 Under Section 560 of the Bankruptcy Code, the automatic stay provisions may not prevent a swap participant from causing the termination of a swap agreement.7 If a counterparty to a weather derivative transaction declares bankruptcy, the non-bankrupt counterparty can terminate, and close-out on a net basis, its positions.8 The non-bankrupt weather derivative counterparty will not be subject to the automatic stay provisions of the US Bankruptcy Code and any payments received by such party either before, or after, the bankruptcy in connection with the liquidation of transactions will not be reclaimed for the debtor's estate by the trustee in bankruptcy. It is worth highlighting that while any end-user can purchase an insurance policy, those wishing to purchase a derivative under ISDA must qualify as an `eligible contract participant.'9
Credit risk, or the risk of loss in the event a counterparty to a transaction fails to perform on a contractual obligation, exists in all weather risk management transactions. The magnitude and nature of such risk is dependent on the specific product used to assume, or transfer, the risk. In the weather market, the maximum amount of credit exposure that can be generated from a single weather protection trade (whether derivative or insurance) is limited, as it is common practice to cap the maximum payout allowable under a given cover. For portfolios of trades the computation is somewhat more complex as it is based on the potential payouts of multiple trades; this typically requires use of correlations and statistical confidence levels.
The nature of credit exposure is dependent on the product and participants. For instance, a risk provider that offers a weather risk insurance policy to an end-user faces no credit risk; once premium has been received, the end-user bears the credit risk of the risk provider. In most cases those writing weather risk policies are highly-rated re/insurance companies, so the actual credit risk assumed by the end-user is typically small. Obviously, if the cover is being written by a weak insurer, the end-user must exercise greater caution. The same scenario exists when a risk provider sells an end-user a weather derivative: the end-user bears the credit risk of the risk provider. In this case the end-user must be especially diligent about reviewing the credit of the risk provider. Since weak investment grade, and even sub-investment grade, risk providers might write derivative-based weather protection, the spectre of default is higher than if the provider is a well-rated re/insurer. This point was made very clear by the bankruptcy of US energy company Enron in 2001. Enron, which was rated BBB+ (mid-investment grade) prior to its rapid financial deterioration, was an active writer of weather derivative protection. End-users (and market-makers) that purchased weather derivative protection from Enron, expecting an economic payout in the event certain weather conditions occurred, now stand little chance of receiving any payments due.
In certain instances a risk provider faces the credit risk of the end-user. This happens when a risk solution requires the end-user to sell the risk provider a weather obligation such as one leg of a two-way swap (e.g. a collar with the same strike) or the second option of a collar (e.g. once the end-user has protected the downside, it may be willing to give up some upside in order to lower the effective premium). In this case the provider is exposed to the end-user, making analysis of the end-user's credit a necessity. Where necessary, collateral or margining arrangements can be used to help mitigate risk.
Institutions that are active in the weather risk management market (as providers, or as end-users engaged in multiple transactions) can benefit from the netting effects provided by ISDA documentation. As noted before, the existence of an ISDA agreement has the effect of allowing all trades under the master agreement to be condensed down to a single payment or receipt in the event of counterparty default. This allows parties to consider, and manage, their credit exposures on a net, rather than gross, basis.
Though it is possible to structure insurance and derivative-based risk management solutions to cover virtually any type of weather contingency, tax, accounting, legal and credit issues should always be considered in order to identify the best form of protection.
Each risk provider and end-user faces unique requirements that are specific to its own operations and which need to be analysed prior to selecting the right form of weather protection. Being able to select from among a variety of instruments, with different financial, legal and risk characteristics, gives end-users a greater amount of flexibility - flexibility that should help the market expand even further over the coming years.
1 Streamflow is a measure of the amount of water flowing in a river and is of major importance to utilities that generate electricity through hydroelectric turbines. Low levels of streamflow (caused by insufficient precipitation and/or cold temperatures that do not permit snowcaps to melt) can impair a hydroelectric utility's ability to generate power and deliver electricity to customers.
2 Temperature is highly correlated to energy demand; the higher the temperature, the greater demand for air conditioning and the lower the temperature the greater the demand for space heating. As a result, many energy companies are active in the non-catastrophic weather risk market as risk providers and/or end-users.
3 `The Weather Risk Management Industry: Survey Findings, November 1997-March 2001', PricewaterhouseCoopers, June 2001.
4 The cooling degree day index subtracts from the average daily temperature a baseline that is typically set at 65° Fahrenheit; a hotter day thus produces more cooling degree days. The heating degree day (HDD) index subtracts from a baseline (again, generally 65°F) the average daily temperature. CDDs and HDDs are two of the most widely used temperature indexes in the market.
5 Set forth in specific treatment of insurance contracts, derivatives instruments under SFAS 133 and derivatives instruments under EITF99-2.
6 A `swap participant' is defined as "an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor." 11 USC Section 101(53C). Thus, if a company has a `swap' transaction with a debtor prior to its bankruptcy, then it would be deemed a swap participant.
7 Per Section 1(c) of the printed ISDA Master Agreement form, the Agreement itself, the Schedule to the ISDA Master Agreement and all transaction confirmations are considered one swap agreement under Section 560.
8 Close-out netting must be distinguished between on-going netting. Parties who wish to engage in on-going netting of transactions must make an election that "subparagraph (ii) of Section 2(c) of the ISDA Master Agreement will not apply." Making that election in the Schedule to the ISDA Master Agreement allows parties to elect for two or more transactions that a net amount will be determined for all amounts payable on the same date and in the same currency, regardless of whether those amounts are due and payable for the same transaction. On the other hand, close-out netting occurs under Section 6(e) of the ISDA Master Agreement upon an `Early Termination Event'. Where there is a Master Agreement in place between two parties, it is not clear under current law whether a non-bankrupt counterparty which has many different kinds of transactions with the bankrupt counterparty can net securities, commodities, forwards, repurchase agreements and swaps under the single ISDA Master Agreement. Section 7 of the Financial Contract Netting Improvement Act of 2001 contains cross-product netting provisions that clarify the enforceability of such provisions and expands the scope of transactions to which such provisions would apply. The passage of this legislation would allow the netting of different products among counterparties.
9 Derivatives are exempt from regulation by the Commodity Futures Trading Commission provided they are made between `eligible swap participants' (e.g. banks and trust companies, insurance companies, corporations, trusts with total assets exceeding $10m, and so forth), are not part of a fungible or standardised class of agreements and are not traded on an exchange, and involve the extension of credit (or acceptance of credit enhancement). The Commodity Futures Modernisation Act of 2000 (CFMA) updated the `swap' terminology. Under the CFMA, `excluded commodities' are excluded from the Commodity Exchange Acts if the derivative transactions are entered solely between `eligible contract participants' and are not conducted on a `trading facility.' Insurance companies, financial institutions, employee benefit plans and broker-dealers qualify as `eligible contract participants.' 7 USC Section 1A(12) and 7
USC Section 1A(33).
By Erik Banks
Erik Banks is Chief Risk Officer of Element Re. Element Re can be contacted at
203 356 3580 or www.elementre.com