Weather Derivatives Offer New Solutions to anOld Problem

The market in weather derivatives has really developed over the last five years,” said Diego Wauters, executive director and global head of SG Insurance and Weather Derivatives, a specialized division of French Bank Société Générale in London. Wauters, who formerly headed AIG Combined Risks, is recognized as one of the pioneers in the creation of weather derivative products. The U.S. has seen their placement grow from nothing five years ago into a substantial industry, with $7.5 billion traded in the last four years, according to Wauters.

Energy suppliers, notably Aquila, Enron, Amerada Hess and others, are primarily responsible. They were the first to realize that this peculiar type of insurance—the weather derivative (WD)—could be of great value in protecting their income from temperature swings that frequently deviate from “normal conditions.” WD’s are as much hedging devices as they are classic insurance. They mitigate the economic consequences of an abnormal number of hot, cold, wet or dry days that affect the income of a particular business.

Most commentators describe property/casualty insurance, even if extended to provide business interruption and/or lost profits protection, as essentially covering high-risk, low-probability events—fires, floods and other disasters. WD’s on the other hand cover low-risk, high-probability events—a warmer winter causes a power company’s customers to buy less gas or electricity; a significant number of rainy days decreases the number of people who may visit an amusement park; lack of snowfall means fewer people at ski resorts, etc.

WD’s cover neither the risks inherent in running a business, nor the effects of price increases/decreases, but the effects of reduced business volume. They are the close cousins of other hedging products, such as futures contracts, commodity options, foreign exchange swaps and credit securitizations.

They are based on indexes, which closely monitor the incidence of “normal” weather patterns over a period of time—as short as a month to as long as a year. Wauters indicated that most contracts cover a particular season, usually winters, which are prone to more extreme weather conditions. Once norms are established, a payment schedule is set based on the company’s anticipated revenues during the option period. Payments are due, or triggered, if those norms are exceeded. This establishes the “strike price,” the level at which the amount the buyer can receive equals the premium paid for the option; for example, when a mild winter produces a certain number of days above a given heat threshold.

In order to create a WD, someone has to provide the capital, which makes the role of banks and investment funds a crucial part of the operation. Wauters manages around $400 million for SG, “half of it in cat bonds and half of it in weather hedge options.” The fund sells the underlying option contract to the buyer, who pays a premium to acquire it. The fund assumes the risk that it will have to pay if certain conditions are fulfilled. In this sense, it resembles classic insurance coverage, but an option isn’t generally considered as an insurance policy and isn’t regulated by the rules that normally control insurance.

The contracts themselves have become tradable commodities, giving rise to the formation of several exchanges that can place derivative contracts, and arrange trades or swaps to reduce risk exposures. The International Swaps and Derivatives Association runs one of the best known. This feature provides the seller with the necessary opportunity to mitigate the risk of having to pay off on a number of contracts in any one region by spreading them over different geographical and commercial areas. Wauters indicated that no more than 15 percent of SG’s fund can be invested in any one particular region.

One of the keys to successfully marketing WD’s is calculating their value. Dr. Gordon Woo, senior consultant in London for EQECAT Inc., observed that, “A weather derivative has a payoff based on some observable aspect of the weather, but this is not a tradable asset. Unlike stocks, bonds or commodities, weather is not a tangible object which can be bought and hoarded.” Dr. Woo specializes in constructing complicated mathematical probability models to try and set the fair value of securitizations and derivative contracts, but he readily admits that forecasting the weather combines aspects of science, experience and most importantly accurate data accumulation. “The better the data, the better the forecast.”

WD’s rely on accurate measurements to produce the data that sets the strike price, triggers possible payments and establishes the premium levels. The two most frequently used are:

Heating Degree Day (HDD) – a unit of temperature and time that measures the extent of cold for a given period. A number of base references can be used, but the most common is 65°F (18°C), used to calculate winter temperatures.

Cooling Degree Day (CDD) – a unit of temperature and time that measures the extent of heat for a given period. It’s used to calculate summer temperatures, and the most common base is also 65°F.

There are also a number of measurements that calculate rainfall, snowfall, wave height, wind speed, sunshine and humidity. They may be employed separately, or in combination with other indices.

The data is extrapolated from government weather stations. In the U.S. the National Climatic Data Center, an agency of the U.S. Department of Commerce, is responsible for the collection, retention and dissemination of climatic information, and is used as the independent data source for calculating the financial settlement of WD contracts. Similar agencies perform the same function in other countries.

There are three main markets, according to Wauters: “The U.S., which accounts for about 90 percent of all the [weather derivative] trades, mostly based on temperature [energy]; Europe, which is about half energy and half non-energy; and Japan, which is mostly non-energy related.”

While energy-related WD’s predominate in the U.S., there’s no reason they can’t be profitably employed in other sectors. Wauters identified agriculture, the leisure industry, construction enterprises and food and beverage providers as having particular exposure to weather fluctuations, and therefore as prime sources of growth for WD providers. SG has a contract in North America covering snow removal, if it exceeds a certain specified level. Its clients also include water companies, who sell less water if summer temperatures are below normal, or there’s excessive rainfall, beverage providers, and “even a zoo.”

While WD’s are currently employed mainly by large corporations to mitigate weather-related risks, they are becoming increasingly available to smaller customers as well. Both Marsh and Aon have established Weather Solutions and Weather Derivatives units. Aquila, one of the biggest energy traders, recently announced a new service, “Risk 180,” tailored for “utilities, municipalities, energy aggregators and small energy marketers, as well as large industrial firms.”

Wauters declined to predict what the future holds for weather derivatives, but said he hoped their use would increase. From the growth figures in the market over the last five years, it seems that his hopes will be realized.