Death, taxes and weather are universal factors that we cannot escape or control. For years, society has unsuccessfully tried to manipulate these forces that regulate our lives. Though we have not managed to control the weather, we can control its effect on our finances. In the past, companies in most industries accepted the impact of weather as an inevitable element of nature and simply absorbed the financial burden of volatile climate patterns. However, in 1997, utility companies in the US, whose revenues are intimately tied to the weather, began to purchase derivative contracts to protect their profits from the effects of warmer than normal winters. This was driven by the deregulation of the utility industry, which forced utilities to focus on profits and shareholder value more than ever. Now, four years later, weather risk management has gone from a little-known industry to a $7.5bn international industry of brokers, traders, banks, consultants, insurers, reinsurers and government agencies that are driving one of the most innovative segments of risk management. This global industry has provided financial stability for end-users not only in the utility and energy sectors, but also in the fields of entertainment, agriculture, retail, transportation, and food and beverage.
In June 2001, the Weather Risk Management Association (WRMA) released a comprehensive survey of the industry in conjunction with PricewaterhouseCoopers, measuring contracts from winter 1997 through winter 2000. This was an important achievement, as the industry's growth and current size had never been accurately measured. A key development tracked in the survey was the tremendous growth in the number of contracts executed. In the winter of 1997, 82 contracts were executed with a total notional value of $169,410, while in the winter of 2000, 1,633 contracts were completed with a total value of $1.8m.
The survey also revealed that the industry has begun to diversify. Over 70% of businesses are exposed to financial weather risk. In the US alone, the Department of Commerce estimated corporate weather exposure at $1trn - approximately one eighth of the gross domestic product. In the winter of 1997, 100% of the transactions took place in North America and protected against warmer than normal winters. While temperature-related contracts continue to make up the majority of the market, there has been encouraging progress in other areas. In the US, weather risk financial tools have been used to cover risk related to stream flow, crop yield, excess inventory and even ice cream sales. In the European, Asian and Australian markets, there has been an increased number of utility contracts and weather deals to protect against temperature and precipitation. While consisting of only a small part of the total weather risk management industry, the over $184m in notional values that have been written in these markets demonstrate the remarkable - and rapid - development.
The rapid growth of the industry is attributed to companies realising that their revenue and profits are no longer at the mercy of the weather. As they have hedged against interest rates and currency fluctuations, they are able to protect themselves from the risks associated with fluctuations in the weather. Equity analysts and the general financial community, who cite the purchase of weather products as a significant factor in their ratings of companies, increasingly support this decision.
In November 2000, Goldman Sachs named Washington Gas Light's purchase of weather insurance as a positive for its shareholders. Likewise, Atmos Energy Corp, a US natural gas distributor, received a higher earnings-per-share estimate in January 2001 from Salomon Smith Barney because of its weather hedging. In addition, analysts at Goldman Sachs, Standard & Poor's and CIBC World Markets have cited a company's decision to mitigate its weather risk as a choice that will enhance its value as well as its credit rating. The consensus is that hedging weather allows a company to continue to focus on the growth and stability of its core business and to enhance the value of its products, services and capital development.
Weather risk management products come in the form of derivatives or insurance, and both products are widely used in the marketplace. Both can be customised and easily structured to suit the need of any company. Generally speaking, derivatives are often purchased by companies with experience in hedging, such as utility and energy companies which have traditionally purchased index-based derivatives. Those which historically have never hedged their risk, such as the agricultural and entertainment industries, often prefer insurance. A derivative can be structured so that there is no up-front payment while insurance requires that a premium is paid. There are also differences in the way each must be reported and taxed.
Before 1997, purchasing weather derivatives was virtually unheard of in industries other than utility and energy. However, the insurance industry is beginning to play an important role in bringing weather risk management to companies outside the utility/energy realm. In the past, insurance has simply provided coverage for catastrophic weather events like storms, hurricanes, floods and tornadoes. The non-catastrophic weather market, which protects against precipitation, snowfall and temperatures, is giving re/insurers the opportunity to greatly expand the protection they provide to customers. It is not only an exciting convergence of insurance and the larger financial markets, but a natural extension of coverage that the industry has already been providing. The challenge for re/insurers is educating their customers, which are often unaware of non-catastrophic weather hedging and how these new products can help them. The success of this endeavour will not only strengthen the weather risk industry, but the insurance industry as well, which has long been viewed as a mature market with little room for innovation.
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|Frequency of contract types|
|Percentage distribution for number of contracts by type of contract, by coverage period, all regions|
|Coverage period||Exclusively temperature contracts||Other contract types||Total|