Weather risk management is reinventing itself for growth.
It was a market born back to front. Nearly snuffed out in the aftermath of the Enron and energy trading collapse, the weather derivatives market has now straightened itself out and is poised for growth - or at least that is what its major players are hoping. Weather derivatives were invented in the late 1990s by a handful of traders in US energy companies. They swapped their firms' weather exposures between themselves in the form of instruments fashioned on those used in the financial and later the energy markets. This meant that a secondary market in weather risk was created before a primary market had the opportunity to take off, according to Ravi Nathan, Senior Vice President at Philadelphia-based ACE USA Global Weather.
"Traditionally, a risk is written first for an end-user, then it is hedged," he said. But in the case of the weather market the primary market couldn't keep up. Mr Nathan was formerly head of weather trading at US energy company Aquila Inc and joined ACE earlier this year. This is a significant change in corporate culture but one which he hopes he will be able to use to build a large book of weather business from the ground up. And the starting point is to deal with end-users; clients whose business is impacted significantly by weather conditions. The weather conditions in question are not the natural catastrophes of major floods and windstorms, but the more subtle variations such as cooler summers and warmer winters. At the moment, the most important clients remain the energy industries, as both energy demand and prices are highly weather dependent. But these eventually will include the construction business, leisure, agriculture, food, drinks manufacturers and the like.
Mr Nathan believes he can best achieve this market growth with a major insurer, rather than a reinsurer or a hedge fund. And ACE, with its huge primary market in property, crops, entertainment and agriculture, as well as operations in 50 countries, is the ideal starting block. "If a company is focussing on the primary market you are in the best position possible. You can always use the secondary market," he said. But putting together a speculative book of weather business is not a good idea in this post-Enron world. For a start, no company management would be prepared to tolerate the kind of earnings volatility such business brings in its wake.
Today's weather market is all about focussing on the end-user, whoever the player. As the collapse of US energy companies withdrew much capital from the weather derivatives market, re/insurers and banks have slowly been dipping their toes in. This switch has been brought about not so much by the financial institutions themselves seizing an open opportunity, but rather the original weather traders recycling themselves out of the energy industry and into finance. And they are bringing their good business reputations, not the unfortunate baggage of the energy industry collapse, with them. Only one of the four energy companies which built up the weather market is still in business. But the key players in these companies that have now been hired by the re/insurers have a high personal reputation, noted Markus Rudolf, Assistant Vice President of North America treaty department at Hannover Re. This shows that the business model created by them was not the cause of the energy companies' collapse, he said.
Swiss Re had a substantial weather-trading book until 2000, lately cutting back significantly. But now the aim is discipline and the end-user.
"What has been highlighted in transactions today is that there is a counter-party which benefits from the risk management tool as opposed to a preponderance of speculative trading," said Mark Tawney, Managing Director of Weather Risk Management at Swiss Re Financial Products in New York. Mr Tawney was formerly head of weather trading at Enron. "Reinsurers and financial institutions are now taking a more disciplined approach, including understanding and fully mitigating credit exposure," he added.
William Windle, Senior Vice President of weather derivatives at Swiss Re Financial Products, explains the different approach to be taken today by reinsurers. "One of the differences you will see with reinsurers (versus the energy traders) is in the nature of risk which may be mitigated. Speculators primarily look at trading risks which are liquid. Reinsurers look in terms of both underwriting and trading risk." Reinsurers have the ability to warehouse a risk and to hedge it out when the opportunity presents itself.
Markus Rudolf explained that in today's market, credit evaluation will be more intensive and will take much more time than it did in the past. But the entrance of financial institutions into the weather market would have happened anyway, thought Mike Corbally, Executive Vice President at Stanford, Connecticut-based XL Weather & Energy. Instead of speculative business, now the main focus will be on the provision of risk management tools for corporate customers. Ravi Nathan agreed. "The client doesn't give a hoot if a risk is best managed by a derivative or by insurance. If I want a swap I can get what is best," he said.
Double trigger products
All of the new players are promoting double trigger insurance products to their new customers. Originally fashioned with the energy sector in mind when that industry was deregulating throughout the 1990s, this can protect an end-user's earnings given two events, one weather-related and one related to the nature of the business. So if, for example, an electricity distribution company is faced with a sudden surge in demand because of unseasonable temperatures, it may have to purchase extra power on the spot market just when prices spike. The policy pays out compensation if the temperature rises (or falls) below a state threshold and spot market electricity prices rise above a second threshold.
The contingency risk team at XL Weather & Energy deals precisely with such crossover risks between two different markets. Earlier this year, it increased this team by another six executives, hired mostly from the energy firm Aquila. The crossover product can be adapted to the agriculture sector, said Mr Nathan. If a crop such as coffee is hit by a late frost, and coffee prices are high, then the farmer can receive a payout once the temperature and commodity price pass certain thresholds.
Companies providing the cover will be able to balance their portfolios by offsetting different weather risks against each other. A warm winter may mean losses if the re/insurer has to pay compensation to an energy company client whose earnings fall below a given threshold. But a construction company client would benefit from benign winter weather and not register a claim. Mr Nathan believes that with such offsets it would be possible to write some $500m of stand-alone business.
Swiss Re has devised a derivatives-based product to protect company earnings. Last September, the largest US heating oil company bought a four-year, $40m weather programme with a floating strike price. This was because the company was hit by unseasonably warm weather during the 2001 winter, leading to a loss in earnings. The cover is based on normalised weather conditions over the past ten years and covers temperatures which are 20% warmer than normal. In addition, it is linked to the company's annual budget and effectively protects cash flow.
But Hannover Re is adopting a different strategy in the weather market. The company does not hold any individual risk positions and does not provide any facultative reinsurance. Rather it participates in the weather portfolio of its partners Mitsui-Sumitomo Insurance Co and GuaranteedWeather of Bermuda. This group bought the weather risk management systems and assets of energy company Aquila Merchant Services in April this year. But in common with other re/insurers, the game here is also weather risk management, rather than trading alone.
The new weather market is also inching towards a version of natural catastrophe cover. In May 2002, Tokio Fire and Marine Insurance introduced typhoon derivatives. In this deal, payout to the client depends on the number of typhoons passing through a given observation area or between a so-called gate between two pre-agreed points. The company has drawn up ten such passage gates in the Japanese Islands with a spot in the sea around. According to Toshihiko Aizawa, Manager at the product development group in the commercial lines underwriting department of Tokio Marine, this kind of product is useful for hotel and leisure industry. If customers cancel reservations because of the fear that a typhoon may hit the location, the client faces a serious loss of earnings.
"Some clients prefer derivatives contracts to insurance. It takes time to determine insurance payments, while in the case of derivatives, the payment is determined quickly," Mr Aizawa explained. But it is in the nature of typhoons to shift their course and a client could be facing loss of earnings if both typhoon and customers stay away. So this year Tokio Marine & Fire introduced a flip side typhoon derivative where buyers would be compensated if the storms happen less frequently than expected. Such products may also cover construction companies for loss of earnings if the typhoon season is thinner and the companies lose out on new business.
For the moment neither Swiss Re, nor ACE, nor XL Weather & Energy are considering a similar product. But Ravi Nathan is enthusiastic about the innovation. "One shouldn't limit oneself," he said.
The restyled weather market is maintaining its growth momentum despite adverse economic conditions in the US and elsewhere, according to the latest annual market survey by the Miami-based Weather Risk Management Association (WRMA) and PricewaterhouseCoopers. During the survey period of April 2002 to March 2003, some 11,756 weather risk management contracts were transacted. The notional value of these contracts was $4.2bn. Last year's survey recorded 3,937 contracts with a notional value of $4.3bn. WRMA said this indicated a surge in smaller contracts and broader spectrum of uses. Weather risk management futures and options traded on the Chicago Mercantile Exchange (CME) totalled 7,239 while over-the-counter (OTC) risk transfers totalled 4,517. OTC contracts climbed 14% from the 2002 survey. Very few trades in weather risk management instruments occurred through the CME during the previous survey period.
Markus Rudolf thought that trading will continue to focus on smaller contracts covering high frequency and low severity events. The CME has been central to this development as the first exchange in the world to offer exchange-traded weather derivatives complete with the benefits of price transparency and clearing house guarantees. In May this year, the CME added another six new seasonal weather contracts to its suite of products.
The most significant changes occurred outside the US. The European market registered a total of 1,480 contracts compared with 765 contracts measured in 2002, an increase of more than 90%. In Asia, 815 contracts were completed, an increase of nearly 85% compared with 445 contracts in the 2002 survey. The North American market remains the industry's largest, with the number of contracts totalling 2,217, a decline of 20% over the previous year's 2,712 contracts.
When Amsterdam-based ABN AMRO bank contracted a ¤126m weather derivative with a Dutch construction company, it nearly doubled the notional value of the European weather market at the time. By contrast in Asia, market growth has been through smaller users. Toshihiko Aizawa believes that the main areas for Asian growth will be Japan and South Korea. The growth potential in other Asian countries could be problematical firstly because the meteorological data needed for price and risk assessments is not as available or reliable, and secondly, because of continued regulatory uncertainties about accounting rules for such transactions. Tokio Fire & Marine for its part is keen to expand in the European and North American markets.
Valerie Cooper, Executive Director of WRMA, explained that the US decline in contract numbers is largely due to the continued exit of energy company players from the weather market. But another significant fact the survey uncovered has been a diversification of the types of contracts used. Weather protection has been traditionally temperature-related and this still accounts for approximately 85% of all contracts, compared with 90% in the 2002 survey. But now rain-related contracts have grown to 8.6% of the total, compared with 6.9% in 2002, with wind contracts at 1.6% (0.3% in 2002) and snow at 2.1% (2.2% in 2002).
WRMA noted that the US Department of Commerce estimates that one-third of the US economy, or $3.5trn, is at risk due to the weather. Ravi Nathan believes that this proportion is probably closer to 10%, but nevertheless is a significant weather risk exposure. So the aim now for all of the new market players and the WRMA is to persuade the rest of the economy to protect itself from future portents. "Our biggest challenge now is educating end-users," Ms Cooper said.
But the youthful weather market itself may need some of that education. There is no real weather-related loss experience. This is something which could hit the market as northern hemisphere climates undergo some of their periodical shifts. But will end-users need these risk management products if weather forecasts improve? In theory, no. However, Mr Nathan doubts this, as such forecasts only have several days of reliability, if that. But for the moment, betting on the weather is a growth business.
By Maria Kielmas
Maria Kielmas is a freelance journalist and consultant.