Weather risk management: The heat is on
The weather-related marketplace is poised for rapid growth
By Michael J. Moody, MBA, ARM
Weather risk management has two primary aspects. The first, according to the Weather Risk Management Association (WRMA), deals with the "management of the financial consequences that adverse weather causes for those with natural exposures to weather." The second has to do with "commercial trading of weather risk, both in its own right and in conjunction with a variety of other commodities."
Currently, the use of weather related risk transfer mechanisms that are based on temperature, snow, rain, wind, etc., make it possible to manage adverse financial impacts. So a business that may be affected by one or more weather elements pays a premium to a risk taker who then reimburses the business for any corresponding loss or additional costs caused by weather.
Weather risk management is a somewhat recent development. The current weather risk market started with three precedent-setting transactions (two of which involved Enron) which occurred in the autumn of 1997. The key to their work focused on the use of improved weather data for measurable variables such as temperature or precipitation as the basis for risk indices. The evolving risk indices made weather risk management possible. In the beginning, risk was expressed and transferred in terms of temperature variables. These continue to be the most used type of measurable variables.
In a typical temperature transaction, if the temperature exceeds a prearranged threshold over a predetermined time frame, it would result in a loss. The buyer is entitled to receive payment from the seller based on the extent to which the average temperature exceeds this threshold. Understandably, the amount of payment is determined in advance, in accordance with the buyer's sensitivity to adverse changes in weather. In the current weather market, risk can be transferred in this manner in the form of index-based derivative transactions built on similar weather indices.
The idea of transferring weather risk isn't new; agricultural insurance such as drought or hail insurance, has been available for some time. Additionally, there is contingency insurance for public events such as sporting events, concerts, etc.
Temperature contingent power supply agreements were in existence before the autumn of 1997. The concept of systematically managing gas utility temperature risk had been put forth 15 years before in the gas and natural fuel industry which created gas-utility mutuals to pool temperature risk expressed in terms of heating or cooling degree days.
Unlike previous efforts, the new weather risk market provides index-based risk transfer for major weather variables such as temperature extremes, snow, high wind, daylight hours, humidity and other variables. It establishes specific loss formulas that transfer risk on the basis of aggregate measurements as opposed to single events.
Despite its short history, weather risk management has experienced a rapid evolution. One of the major changes is the active involvement of the Chicago Mercantile Exchange (CME). It's the CME that has been able to function as a strong secondary financial market for those wishing to participate at that level. Up until the CME's involvement, the market was greatly limited due to the lack of a liquid, secondary market.
Over time, weather risk management has expanded significantly geographically as well—with present weather risk being transacted on risk from all parts of the world—in particular, North America, Japan and Europe. Emerging from its origins, which were dominated by the energy business, the market now encompasses a wide variety of sectors including agriculture, construction, transportation and even entertainment. Trading of weather risk often in conjunction with commodity or energy risk has mushroomed and has attained a critical mass on the CME. The Weather Risk Management Association has emerged as an important contributor to the overall conversation about weather risk for a wide variety of businesses and governmental entities.
The wide range of capital providers which make up the weather risk market make it possible for investors in the risk marketplace to manage their portfolios and for market participants to find value in the dynamics of the marketplace itself. With the involvement of the Chicago Mercantile Exchange, weather risk management vehicles are liquid with ready buyers at all times. It's the ability to diversify investors' portfolios that has helped to propel weather risk management to current levels.
Successful growth within the weather-related marketplace can be seen from the growth of custom weather derivatives, according to the Weather Risk Management Association, which grew by nearly 30% while the overall market increased by 20% to total notational value for over-the-counter trading contracts of $2.4 billion in 2010/ 2011 while the overall market grew to $11.8 billion. The latest survey results were released about one year ago.
Worldwide, temperature contracts remain the most traded customized weather related derivatives. Growth can also be seen in rainfall, snow, and hurricane contracts. It should be noted that these also represent increases in user participation from a wider variety of industries such as agriculture, construction, and transportation. Geographically the number of contracts traded rose in the U.S., Asia, Australia and Europe—all posting big gains.
The WRMA indicates that the increased participation from a wide variety of end users is only one more signal of the increasing utilization of these contracts. The increased balance between exchange traded markets and the OTC market demonstrates greater interaction between market participants, which then creates a stronger platform for future growth.
In essence, weather risk management represents two sides of the same coin. Weather risk management which flows through the Chicago Mercantile Exchange is, in effect, weather risk that can cause immediate variability in the earnings of its holders. The other side of the weather risk management coin deals much more with risk due to climate change, which has longer-term repercussions. These longer-term issues involve mechanisms that traditionally are limited to other insurance companies. Traditional weather risk management deals primarily with purchasers that are directly involved with the results of day-to-day weather variables.
There are a variety of weather related alternative risk transfer mechanisms, but whether they are used by any of the various individual business sectors, all have a similar goal. The goal is to mitigate or at least reduce the effects of weather on various activities. Without question the increasing awareness of climate change has increased the overall weather risk management segment of the business.
There are a number of considerations that speak directly to an increasing market with regard to weather-related risk: improvements in forecasting, emerging players, greater regulatory constraints, and more active than normal hurricane seasons.
All of these issues point to a much stronger and accessible weather risk management program that many corporate risk managers and insurance professionals can take advantage of. Long-term, these types of programs should begin to appear in the strategic risk management programs of individual participants. Because this segment is poised for rapid growth, property and casualty insurance brokers should keep up with advances in this marketplace. Educating clients on the advantages of weather risk management is an important value-added service.