Saving for a rainy day has taken on a whole new meaning. Weather derivatives, discovers Ronald Gift Mullins, are no longer a novelty.

Usually, when the weather makes screaming headlines, it is from the massive destructive power of Mother Nature producing howling hurricanes, terrible twisters, trembling earthquakes or cold snaps bringing hail and ice. Yet the slight gradations of temperature over a month or a season can also generate a profit or a loss for a company.

Providing some measure of protection for these climatic fluctuations are weather derivatives. Put simply, a derivative contract identifies a particular financial instrument that has no value in itself, but derives its value from assets or data that support it such as stocks, bonds, currencies, commodities, real estate or even weather.

Weather derivatives first appeared more than a decade ago when Aquila Energy executed a weather option for Consolidated Edison in New York that was embedded in a power contract. This was before the warm winter brought on by El Niño in 1997-1998. The weather derivative market grew slowly but surely, until the collapse of Enron in December 2001.

The energy company had encouraged its clients to use derivatives to maintain profit from weather variations. When Enron took bankruptcy, weather derivatives as unknown and slightly shady instruments were blamed as having some culpability in Enron’s downfall. Use of the devices diminished, but slowly over the next few years, trust and interest returned.

Measuring weather “coolness”

The basic trade inherent in weather-related risk management products is indexed on the Heating Degree Day (HDD), a widely-used measure for the relative “coolness” of the weather in a given region during a specified period of time. HDDs are calculated using temperature data provided by the National Weather Service.

Weather derivatives can hedge against temperatures that are too high for one industry and too low for another. For natural gas and propane/heating oil companies, a very important factor determining profit or loss for the company is the severity and duration of the winter. Warm winters can seriously affect the financial results of these companies, as the volume of natural gas and heating oil that is consumed during the winter season determines their sales revenue and profits to a great extent. Thus natural gas companies hedge against warm winters. The opposite is true for electric utilities. Cool summers reduce the demand for air conditioning which lessens the volume of electricity sold.

“Weather derivatives were blamed as having some culpability in Enron’s downfall

Other industries and facilities use weather derivatives extensively. Crop and livestock handlers are highly dependent on weather conditions. Depending on a host of weather conditions – drought, flooding, early frost, late spring – the yield of a crop can vary greatly. Further, extreme cold or heat can reduce the gain of livestock, as well as exposure to rain, frost and combinations of such.

One of the most costly losses during Hurricanes Katrina and Rita was the destruction of offshore rigs in the Gulf of Mexico. Not only is destruction of the physical rig possible, but the flying of personnel to safety is costly and shuts down production. Weather can also seriously delay the progress of a construction project. Weather derivatives written into a construction contract can hedge the risks and offset losses associated with adverse weather.

Hurricane indexes

Within the past year, exchange weather contracts have even been created for hurricanes. The Chicago Mercantile Exchange (CME) launched the CME-Carvill Hurricane Index futures and options contract in March. The underlying indexes will be calculated by reinsurance broker Carvill.

Likewise, the New York Mercantile Exchange (Nymex) and Gallagher Re agreed in 2006 to list property damage risk contracts. These contracts will allow the real-time electronic trading of property damage risk exposures, including hurricane risk through a cleared futures exchange. The contracts will be financially settled against the Re-Ex Index, which has been created by Gallagher Re. Contracts on both exchanges will be traded and cleared electronically through the Nymex ClearPort and CME Globex platforms.

There are no great differences between the underwriting of a weather derivative and the more traditional weather insurance contract. But there are differences with adjusting a claim. Payouts from derivatives are based on objective data (temperature and precipitation records), not an assessed, measurable loss, which can bring disagreements and delay. With a payout from a derivative, the company with the contract can still profit. There is no moral hazard associated with a derivative, as no one can manipulate the weather.

Weight of weather

“With more and more volatile weather events, you have more and more companies looking for protection from the variables of weather

Buying a weather derivative begins with a company or organisation calculating an index that correlates the product it sells with how the weather affects it. “The company brings its risk to us and we tailor an index to address their risk,” explains Brian O’Hearne, managing director of Swiss Re’s environment and commodity market unit. “If we agree with the statistics after reviewing them, then we will offer a price for the derivative. If we don’t have an appetite for a particular risk, because we are not comfortable with the index, we will first work with the company to revaluate the data and ask it to resubmit.”

He advised companies wanting to buy a weather derivative to “first and foremost know how the weather affects their business, so that they can come up with an index that suits their needs. They must think of the value of the programme to them, balancing the price for the derivative against the benefit.”

Waiting too long to buy a weather derivative can be a bad thing. A good example was the 2006-2007 winter in the US. It started out very warm with balmy temperatures in November and December up to the second week of January. Industries that profit from cold winters – heating oil and natural gas suppliers to ski resorts and snow removal companies – scrambled to buy weather contracts to even out the warm days. Then in February, freezing weather returned and the temperature for the winter turned out to be near average.

“We encourage our clients to look at weather before winter or summer,” says Jean-Christophe Garaix, head of weather derivatives at Paris Re. “Do it too late and you will be sorry. Those who bought contracts at the beginning of January 2007 because it was too warm, would have paid a lot more than if they had bought a seasonal contract before winter began.” Paris Re’s focus is on weather derivatives for energy and agricultural industries. The newly-public French reinsurer is looking to expand its market to include Mexico, India and several countries in Africa and Eastern Europe.

As for the future of weather derivatives, Garaix believes there are two influences that will positively influence the growth of weather derivatives. “First,” he said, “the price of energy is rising fast which has a direct impact on utilities and indirectly on commodities that depend on energy for production. These dependent industries will require derivatives to withstand changes in weather. Second, with more and more volatile weather events, you have more and more companies looking for protection from the variables of weather.”

Weather derivatives are no longer a novelty to industries. Energy, agriculture, construction, banking, recreation, insurance and other sectors see the real value of participating in the weather risk market. Swiss Re’s O’Hearne observes: “Weather risk tools are becoming essential to the bottom line of companies around the globe.”

Swiss Re's landmark catastrophe swap

On 22 August 2007, Swiss Re and Bermudian firm Ascendant took part in the first cleared catastrophe derivatives trade. Brokered by GFI Group, the swap was an option on the nationwide catastrophe risk futures contract on NYMEX.

Rick Pagnani, president and CEO at Ascendant said, “We are happy to have participated in the inaugural trade, but, more importantly, we are excited at the prospects for this market. These cat derivative contracts add a new dimension to risk management and give (re)insurers and capital market participants alike with a new way to enhance risk-adjusted returns.”

Albert Selius, head of the insurance-linked securities trading desk at Swiss Re Capital Markets said: “We are always looking to trade cat risk in the best format. We welcome the NYMEX initiative as it provides an alternative platform for natural catastrophe trading in addition to the traditional industry loss warranties market.”