Last year the skies opened up for weather risk management deals, with the total face value of insurance and derivatives doubling, and the number of contracts traded on the Chicago Mercantile Exchange soaring by a factor of five to almost a million.
According to the annual survey issued in November by PriceWaterhouseCoopers for the Weather Risk Management Association, the total face value for all weather risk management instruments in the 2004-05 survey period was $8.36 billion, a boom of almost 83 percent over the 2003-04 survey. Face, or notional, value had been holding steady at less than $4.6 billion in each of the previous three years
The value of individual trades and the number of trades have increased in both the over-the-counter market and the Chicago Mercantile Exchange, says John Stell, who conducted the survey. "Most of the growth in the number of trades was for contracts based on North American water measure," the authors of the survey write.
Not counting the hedge funds and other speculators, the largest end-use sector for weather risk management contracts in North America is the energy sector. Agriculture remains a major sector in Europe and Asia. Most contracts are written in terms of heating-degree days or cooling-degree days, precipitation, and wind and other temperature measures for smaller specialties.
Whereas municipal buyers prefer insurance products, derivatives are more attractive to the corporate sector because they do not require an insured interest or a proof of loss, says Brian O'Hearne, president of WRMA (pronounced "warma"). "The settlements are prompt once the trigger happens," he says. Among users, hydroelectric utilities are big fans of weather risk management products. "The recent drought in the Northwest was of significant interest," says O'Hearne, who is also CEO of Kansas City, Kan.-based Guaranteed Weather LLC, an independent firm that manages a weather-risk portfolio.
"Hydros on both coasts, as well as Ontario and Quebec, have tremendous exposure both on supply and demand." Buyers, he says, are beginning to get more picky in the structure of the contracts. Some hydroelectric producers, for example, are beginning to ask for so-called "run-of-river" contracts. These agreements guarantee a fixed quantity of water running though a river over a particular distance. "We are starting to see run-of-river contracts in California, as well as traditional precipitation contracts," says O'Hearne. Other hydroelectric producers, feeling more secure, have built-in weather risk management by generating electricity from water coming from different watersheds.
But for users who buy run-of-river and even the more traditional precipitation contracts, the agreements are becoming more complex and more tailored, so as to limit both gains and losses to the buyer, says Jurg Trub, managing director of environmental and commodity markets at Swiss Re, which writes both insurance and derivatives.
The red-hot trading environment has helped, Trub adds, as it means more "price transparency and discovery" for buyers. "End users can check bid and offer prices online these days, and the exchange has a clearinghouse standardization."
Not that skilled buyers of hydroelectric hedges need much help. "Most utilities are extremely well-run in the technology area," says Warren Isom, senior vice president of Willis Re in Philadelphia. "They have a good idea of the range of their equipment and the financial implications of those sensitivities."
While hydroelectric utilities, having generated a reputation among investors for staidness, can't compete with the boiling real-estate market on the cocktail circuit, they are "streets ahead of other industries in understanding and managing weather risk," says Isom. "Other sectors like construction and apparel are just starting to catch on."
One of the most highly respected and experienced utilities in the use of weather risk management is the Sacramento Municipal Utility District. Chief Financial Officer Jim Tracy says SMUD started using weather risk management in October 2000, just before the California energy crisis hit. "We had seen what was happening to prices about nine months before, and realized our exposure if we had a dry hydro year," he says. "If a utility is investor-owned, the rate-payers carry all the risk. We are municipal and have more of a focus on rate stability." Tracy had taken over the business planning in late 1998, and says he saw what the trading companies were starting to do. "The question then was how to put that into an intelligent risk management structure."
That structure now includes nonfinancial contracts to transfer power from supply to demand. "We have crafted a collar where we pay in power when we have a wet hydro season, and get paid in power if it is dry," says Tracy. "We are also trying to create some self-insurance via a rate-stabilization fund. At least we can build the capital to allow for higher premiums."
Hundreds of miles east of Sacramento, Peoples Energy of Chicago uses weather risk management as well, but purely to hedge its own risks.
"We use both insurance and derivatives," says Judy Pokorny, vice president of risk management. "I don't feel that we have to use one over the other. And we are buy-and-hold users, so we do not need to trade out of our positions." The company has been using weather risk management products since 1999.
Pokorny says she is pleased with the growth of the secondary market and the entry of new players such as banks. "The market is now broad enough that we can bring risks to the market and find lots of creative solutions and contingent structures," she says. "But you are going to pay for that complexity, and I don't find prices decreasing."
In contrast to Peoples' buy-and-hold strategy, Constellation Energy of Baltimore is both a user and trader of weather risk management products, offering "mostly derivatives" to customers, says Stuart Rubenstein, chief operating officer of the energy commodity group. "Most of the time we are originating," adds Jason Pickard, a trader of weather derivatives, "but it is not out of the question that a customer will request a little more sophistication." With the number of counterparties in the market doubling in the last 12 to 18 months, liquidity has increased commensurately. "There has definitely been more liquidity in the market in recent years," he says.
The Chicago Mercantile Exchange began trading weather derivatives in 1999, what seems in retrospect the "ice age" of weather-derivatives trading. "It was a slow start," says Felix Carabello, the Merc's associate director of alternative investments. In 2004, only 122,000 contracts were traded. That was surpassed last April, then again last May and yet again last June, which saw more than 100,000 contracts traded in each month. Through October, the volume of contracts traded in 2005 exceeded 700,000. "I don't know if we are going to reach a million," says Carabello, "but this is a great story."
The boom is not just in speculative trading, he says. The government also loosened regulations. "We see this as a complex ecosystem," says Carabello. "There are more originators and end users as well as traders. Volume is also important in convincing people that weather risk is no different than other risk." The Merc offers heating-degree days, cooling-degree days, frost days and cumulative average temperature contracts for 29 cities. More risk categories and cities are being evaluated.
The hot and cold snaps of the trading climate aside, insurance executives insist that insurance products sill dominate when it comes to event protection. This growing segment of the market, however, is still fragmented. Large underwriters in the sector like Ace, St. Paul Travelers, and XL Weather & Energy dominate.
"Our mantra is providing solutions to the end users," says Ravi Nathan, senior vice president of Ace Global Weather in Philadelphia, "and that makes us able to write for very specific risks. The purpose of insurance is to indemnify, not for speculation."
Ace tends to write stated-value insurance, rather than actual-loss coverage, for weather risk management because it makes life simpler for clients. There is no need for proof of loss or claims adjustment. Nathan also says Ace sells only customized insurance contracts that are not usually traded on public exchanges. "The biggest demand for us is hurricane related, and it is very difficult to find that protection on the derivative side," he says. Many of his clients are forbidden from entering into derivatives contracts for legal reasons or because products are not available, like snow protection for municipalities, for example.
XL Weather & Energy in Overland Park, Kan., staffed in part by former executives of the utility industry, uses insurance and derivatives to develop custom solutions for complex weather exposures.
"We have migrated out of the over-the-counter commodity trading," says Joseph Leto, senior managing director. "There are lots of people in that. We prefer to work with end users in helping them manage risk." One subspecialty for XL is generator-outage protection. "If a utility is buying or selling power, the biggest opportunities are during the extreme events," says Leto. "They can make 70 percent to 80 percent of their annual profit in July and August, or January and February. Even a few weeks' outage at the wrong time of year can have a huge effect." XL has been offering this protection as either insurance or a derivative since 2003.
Another new type of coverage is temperature-contingent gas protection, where the trigger is a purchase. Again, this coverage can be in the form of insurance or derivatives. "We have several other types of protection in development," says Leto, "and we will probably be coming out with one or two a year."
Several independents, including Global Weather of Great Neck, N.Y., appear to have carved a secure niche for themselves. But just because insurance products dominate in protecting buyers against inclement weather--fog and lightning, for example--making a living at it is not guaranteed. "There have not been any new carriers in this market," says Pat Sleicher, who has been in the weather insurance business for more than 30 years. "Those that have tried to get in have not done well." Sleicher founded Global Weather in 2000 and writes coverage worldwide. Most of the business is agreed- or actual-value with stepped coverage for the basis risk. "That is popular, but it becomes more expensive on the lower thresholds and less expensive on the higher end."
Christine Ingraham, vice president of weather and special events at the WKF&C Agency of Melville, N.Y., which works with St. Paul Travelers, concurs that the event segment has been tough on new underwriters. "At a time when premiums and deductibles are rising, the challenge is getting the word out that coverage is available, and fighting the assumption that this is ancillary coverage," she says.
"With the crazy weather we have been having the past couple of years, this is actually the coverage clients can least afford to cut," she adds.
"We have been writing since 1998 for small events," says Martin Brezner, managing director of national property. "We are not betting on million- or billion-dollar limits, but the level we are serving is fantastic. The customer base is phenomenal, all but untapped. There is a huge need out there. We would rather write a bunch of policies at a $10,000 limit than just a few at a $1 million limit."
Nathan and other experts say weather coverage is usually without moral hazard--fires can be set, but no one can make it rain--although some hydropower generators wish they could. "Hydros are big users of these contracts both up- and downstream," Nathan says. "The hydro market is becoming increasingly global. Brazil, for example, is a big player."
But the cutting edge of weather risk these days is less in the coverage of niche events than it is in long-term climate change. "We are already seeing the impacts, especially in the areas of hurricane coverage," says Nathan.
There is one exception, of course, to hedging against the weather either with insurance or derivatives, one that not even the world's largest reinsurer, Swiss Re, will cover, even with its recent acquisition of GE Insurance Solutions.
"Antarctica is the one continent where we do not conduct business," says Trüb.
GREGORY DL MORRIS
is a New York-based writer.
January 1, 2006
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