In the markets of insurance and reinsurance, weather risks traditionally have been monitored and valued by catastrophe re/insurance providers. Companies and individuals that suffer damage caused by hurricanes, windstorm, fires and floods have long been indemnified for losses covered by their catastrophe insurance. Historical frequency and severity of covered exposures are the basis for pricing these insurances, and payment under policies is contingent on the occurrence of an indemnifiable loss.
Today, the definition of weather risk is much broader, expanded to include the uncertainty of corporate results caused by non-catastrophic weather volatility impacting companies' revenues, expenses and cash flow. This volatility may include inter-annual variations in temperature of as little as one degree, and similar fluctuations in precipitation, wind speed and snowfall. Any company whose products, services, operating expenses or revenue flow is adversely affected by changes in weather conditions can now benefit from the security provided by a weather risk management product.
The face of the weather market – and its products – has been changing since 1997, when the first weather derivative contracts were traded. Driven by deregulation of the utilities industry, the market for weather derivatives began to emerge in the summer of 1997. No longer able to pass on to customers the higher costs associated with electricity demand peaks, utilities' first response was to hedge this risk with electricity derivatives. When index-based weather derivatives became available, they found some basis risk, but also found the potential for a much broader distribution of counterparties and unquestioned data integrity via the National Weather Service.
As a result of this initial market development, the vast majority of weather contracts written to date are based on temperature, and most are in derivative form under standard industry International Swaps and Derivatives Association (ISDA) agreements. However, many non-energy companies have also recognised that weather volatility can have a significant effect on corporate results. Demand for weather risk management products is now expanding into other business sectors, including agriculture, retail, trucking, leisure, airlines and construction. Adverse weather conditions can no longer be blamed for inadequate corporate performances, as shareholders and analysts alike become aware of the existence of weather contracts as hedging instruments.
Typical weather derivative transactions involve energy end-users approaching market makers to provide hedges to their weather exposures. The market makers (risk takers) then look to exchange these risks, using brokers to find other risk takers to diversify or lay off their positions.
Weather industry market makers currently include: integrated energy trading firms; insurance and reinsurance companies (to the extent they assume net positions in weather risk); hedge funds; and banks. As banks continue to de-emphasise commercial lending and allocate resources to developing capital markets businesses, they are attracted to the benefits that weather risk management products can offer their corporate clients. The growing number of institutions becoming active as market makers has increased market liquidity, providing end-users with more choice of products and providers of risk capacity.
The reinsurance community is beginning to recognise the growth of the weather risk management market as a complementary market in which it can provide additional value. Re/insurance companies and energy marketers have begun to form strategic partnerships, through which the energy marketers gain both capacity and access to a wider client base, and portfolio results are shared with the re/insurance partners.
There has also been an increase in the number of re/insurance companies trading weather derivatives and providing weather risk management products directly to their own client bases. This is a step away from traditional weather catastrophe underwriting, which focuses on low frequency, high severity protection. Weather risk management products are also priced based on historical frequency and severity, but provide coverage at a point much closer to the historical average on the index, rather than at the extremes where catastrophes typically occur. The weather risk management market strives to price its products at a responsible level, and portfolios are carefully monitored to maintain portfolio diversity and adequate spreading of risk.
The risk transferred through weather risk products flows in two directions, unlike the unilateral direction traditional insurance risks take. Market makers are therefore provided with the opportunity to offset risks in a variety of ways. On a directional basis, coverage for warm and cold temperatures, or high and low precipitation levels in a specified geographic area can be offset. Geographical spreading of risk also enables market makers to smooth portfolio results and manage the risks assumed.
The variety, size and number of contracts entered into have increased exponentially each year. In the year 2000, the first weather contracts were written in Asia, Australia and Europe. Although the number of these contracts compared with those written in North America is minimal, it is expected that growth in these will follow a similar course of development. Although the majority of weather contracts are currently based on temperature, the volume of contracts covering rainfall, snowfall and wind is beginning to grow, predominantly in Asia. As more and more business sectors are recognising the effects of other weather factors on their business, market makers are focusing their strategies for targeting end-users, and are using their existing client bases to structure innovative weather risk management programs.
End-user contract volume has been growing slowly as a result of a number of challenges facing this new market. Within the weather risk management industry, market makers have not yet reached consensus regarding valuation methodology for weather transactions. Wide spreads are therefore commonly experienced between the bid and the offer prices of the structures being considered. For end-users, this makes it more difficult to determine the fair market value of the products they are purchasing. However, despite this wide variance among industry analysts, the market now shares an increasing amount of weather data and contract information, assisted greatly by the Weather Risk Management Association (WRMA). This association was established by weather industry professionals to provide forums for financial weather product discussions and interaction, with the goal of creating global standardisation for weather risk contracts.
On the end-user side of this market, corporate executives find it relatively easy to place a value on potential losses the company is exposed to by traditional insurable risks. However, the notion that income streams vulnerable to variations in weather can be protected is still a relatively new concept.
To structure weather risk management transactions, a corporate buyer must be able to identify the specific weather conditions that best reflect the source of their business volatility, so the appropriate measurement index or combination of indexes can be determined.
Cost continues to be a challenge for the weather industry, as end-users are accustomed to insurance pricing, which has been significantly under-rated for a number of years. If no commitment has previously been made to protect against weather risk, it can be difficult to convince corporate executives to increase cash expenditures to cover potential downside risk.
Companies which have overcome these initial challenges understand that weather risk management products are a beneficial tool in managing their business. Weather contracts are now being structured in insurance form to better suit the needs of end-users. These can be structured in such a way as to provide long-term protection that smoothes results over time and rewards end-users if loss experience is favourable. However, the fact remains that companies which have long been exposed to weather risk have managed to perform well over the years despite the lack of weather risk management products being available on the market.
As industry leaders in sectors highly affected by weather fluctuations begin to use these new products to gain an edge, competitors will ultimately follow suit if the weather works against their favour and against their bottom line. When risks go unprotected despite the availability of risk management tools, corporate directors face extreme pressure from shareholders. For this reason, it is probably only a matter of time before weather risk management products become more mainstream. This, combined with the continued success of the secondary market, should lead the weather market into more areas worldwide, more product diversification, and to a more diversified and global client base.