The market for weather derivatives has developed into a sizeable sector over the last five years, but the role of re/insurers is still uncertain, says Valerie Denney.
Insurers and reinsurers have so far played only a peripheral role in the weather market, despite expressing considerable interest. For example, as Swiss Re and Marsh gear up to play a bigger role in weather derivatives, two Bermuda players, Tempest Re and Commercial Risk Partners, have withdrawn from the market. Nevertheless, in Japan insurers are actively developing the market, and Tokio Marine and Fire has created the first typhoon derivative.
The weather market is undoubtedly growing. As Ravi Nathan, outgoing president of the Weather Risk Management Association (WRMA) pointed out at the organisation's recent annual convention: "What was once an industry concentrated almost exclusively in North America and serving mostly utility and energy firms is now responsible for over $11.8bn in business over the course of the last five years."
WRMA's latest survey (see page 50) shows that the number of contracts transacted in the weather market grew by 43% compared to last year (see box for survey details). Not all players participated in the survey, so this is merely an indicator of market development. Europe and Asia have witnessed the most dramatic growth.
Speaking for Europe, Nancy Williams, energy trader at Innogy (UK) which began trading last August, said that while people had been hopeful of growth before, the market has proved explosive. This is largely due to the raft of new banking entrants to the weather derivatives market which include Deutsche Bank, HypoVereinsbank and IntesaBci.
These players are building a strong presence in the industry and developing sophisticated, customised products to meet the demands of end-users. In most cases, however, education is key. Banks are in the perfect position to cross-sell products. While negotiating financial trading deals, they can bring attention to the need to finance weather exposures. Structured transactions can factor weather derivatives into a total risk management package.
For regulatory reasons, insurers in traditional markets may be unable to use derivatives for anything other than hedging their own risks (as Andrew Pincott explains on page 36), but Bermuda offers greater freedom. XL Capital created a subsidiary, Element Re Capital Products, specifically to help businesses manage earnings volatility resulting from variations in weather, such as temperature, rainfall and snowfall. It can provide both re/insurance and financial products.
A recent Element Re deal protects London restaurant The Rock Garden, against financial loss from colder than normal weather. The contract pays out if the maximum daily temperature is less than a pre-agreed level for the month covered for more than a specified number of days. This is the second year the restaurant has purchased a weather product.
"This deal shows the increased interest in weather risk management in Europe as well as the growing diversity of the market," said Lynda Clemmons, president and CEO of Element Re. "Restaurants can be highly affected by weather and this transaction demonstrates one of the many ways we can create a product to protect them."
The lack of sound weather data proved a serious impediment to the growth of weather derivatives in Europe in the past, but observers agree that this is no longer the case. RMS, Weather Exchange, and AIR, among others, have played their part in providing dependable data while the WRMA continues to lobby the European Union and individual governments in an attempt to lower prices for weather data and make its availability more consistent.
Big in Japan
The last year has seen the market in Japan take off in dramatic fashion and in a distinctive manner. Unlike in North America and Europe, where the majority of transactions are within the energy/utility industry and protect against temperature-related loss, the Asian market consists of many small to mid-sized companies in a range of industries that are protecting against temperature, rain, snow and wind.
Tokio Marine is a pioneer in the market. In May 1999, it developed `weather protection insurance' as a hedge against weather risks and in March 2001, the company began to sell a regular pattern product of weather derivatives. In February 2002, it offered customers `Cherry Blossom Viewing Derivatives'.
So far, weather instruments have generally used single climatic factors, such as rain, wind or sunshine, and they have been calibrated on departures from seasonal norms. In April 2002, ahead of the typhoon season, Tokio Marine launched its most innovative product - typhoon derivatives - developed in collaboration with Tokio Marine Risk Consulting Co. It allows businesses to protect themselves against the financial impact of a catastrophe in the form of a typhoon or typhoons, even if they do not suffer direct physical loss. The issue for the buyer is to match its likely exposure as closely as possible to the parametric triggers available for the contract. (See separate box for more details.)
For businesses up and down Japan in June, much was riding on the tourism and travel associated with the 2002 FIFA World Cup, and insurance companies offered weather derivatives to allow these businesses to hedge against any loss of custom. The derivatives, marketed by the likes of Mitsui Sumitomo and Tokio Marine, were particularly aimed at hotels and restaurants. Although no figures are currently available, it is believed that the up-take was significant. The South Korean market is awaiting full deregulation of weather derivatives later this year.
Amid these developments, however, two significant players have withdrawn from the market; ACE subsidiary Tempest Re and Commercial Risk Partners, part of the French reinsurer SCOR, both Bermuda companies. At the time of going to press, no reasons were forthcoming for these decisions. Tempest Re's move did not come as a great surprise since the company has been doing fewer deals of late, but Commercial Risk had a sizeable book of business. One theory doing the rounds is that neither company was comfortable with the way weather derivatives have been developing. As forecasting techniques continue to develop and weather data becomes highly granular, the product is becoming more of a commodity. When both companies started out, the business was more actuarial in nature which may have sat better with their thinking.
"This is still a young market," said Ethan Kahn of Castlebridge Partners, an independent capital markets and insurance consulting/brokerage firm based in Chicago. "It's a case of two steps forward, one step back."
It is generally believed that further fall-out is unlikely, particularly in the re/insurance sector. If anything, the market is expected to continue to broaden. Key re/insurance players include Element Re and Kemper, which have put significant capital investment into the market and are staking out their positions in what is proving to be a period of transition. Given their credit ratings, it would make sense for more re/insurers to get involved, but many companies are still licking their wounds from an earlier foray into weather derivatives when they were an unexplored novelty.
In the US, the Enron collapse has undoubtedly impacted end-user demand, but dispersal of intellectual capital from such a concentrated source can only strengthen and diversify the market. Ex-Enron staff are popping up all the time as new players emerge and existing operations beef up their activity. Just recently, Marsh & McLennan Enterprise Risk established a weather derivatives desk, headed by Partho Ghosh, while Swiss Re has taken on an Enron team with Mark Tawney as managing director of its weather business. Although involved in the weather risk market since the early days, Swiss Re hasn't been particularly active in the last couple of years. That's all set to change now. At the end of May, Swiss Re Financial Products Corp licensed RMS's Climetrix weather derivatives trading and risk management system.
Reports of current activity in US weather derivatives are not too promising. Many market players admit that the summer season has been disappointing and no large deals are on the table for next winter. Granted, it's still early days for winter deals and there are no conclusive El Niño predictions yet, but the brokers Global Reinsurance contacted were distinctly anxious. The atmosphere of recession and Enron's collapse have made their mark.
End-users plan their summer season deals at the end of the year, so this summer is the first litmus test of post-Enron demand. Credit concerns are now key, with end-users increasingly looking at the credit quality of their counterparties. Multi-year deals offering long-term stability with highly rated counterparties are the way many are looking to go. Those happy with short-term seasonal transactions are now turning to the exchanges, such as the Chicago Mercantile Exchange (CME), which previously struggled to draw volume.
The opportunities are certainly there. While the types of contracts transacted are diversifying and forecasting/modelling technology develops apace, players have merely scratched the surface as to how weather products can be used both domestically and on a cross-border basis. Deals will become increasingly structured, with options linked either to a commodity or to another form of weather, such as precipitation. As predicted all along, the market is bifurcating into two distinct camps. One is dominated by short-term, highly liquid deals such as degree-day products transacted by market-makers; the other consists of more exotic structures transacted by the insurance industry and investment banks.
The compelling motivation right now is to broaden the client base:, expanding the market outside the traditional end-users, the utility sector. Industries frequently carrying unmanaged weather risks include agriculture, construction, government maintenance, outdoor entertainment, manufacturing, transportation and retail. "The weather hedge should also be considered by insurance companies," remarked Ms Clemmons of Element Re. "Take car insurers, for example. The incidence of rain, snow or ice must correlate with more accidents. The big hold-up at the moment is that it takes a lot of analytical work."
Many companies still don't perceive weather as a real risk, despite the fact that equity and debt analysts are beginning to support the need for weather hedging as a means of increasing shareholder value. Educating prospective customers will be of paramount importance in the coming years.
Despite the recent blip on the US side, there is little doubt that the weather derivatives market will continue to grow. Estimates of the market's size in a couple of years vary considerably, but all are wildly ambitious. Meanwhile, in keeping with a young market, a myriad of issues which require clarification remain including contract terms, settlement data, and accounting and regulatory uncertainties. No doubt this will sustain attendance numbers in the booming weather derivatives conference circuit.
Tokio Marine typhoon derivatives
This contract will pay an agreed amount if the number of typhoons hitting Japan exceeds a certain number during the set observation period, regardless of whether or not the customer has suffered physical damage.
Customers choose one or more of 47 pre-defined passage areas, each of which is a 150km circle around a prefectural capital. The contract pays an agreed amount when a typhoon passes through these areas.
Customers choose one or more of ten pre-defined gates, lines which connect a spot on the Japanese Islands with a spot in the surrounding sea. The contract pays an agreed amount when a certain number of typhoons have crossed the gate.
Minimum premium: ¥500,000 (about $4,200).
Survey results at a glance
Conducted jointly with PricewaterhouseCoopers, this is WRMA's second annual study of the market. The survey focused on activity in the weather risk industry from 1 April 2001 to 31 March 2002. The results were announced at WRMA's annual convention in Coral Gables, Florida in June.
By Valerie Denney
Valerie Denney is an insurance writer and the editor of the Global Reinsurance special report on weather risks: Don't let the sun set on a stormy balance sheet.