| Weather Risk 101 |
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| 30/09/2007 | |
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Warren Isom, senior Vice President of Willis Re Inc, answers this week's questions on Weather Risk Management. 1. What is weather risk management and when did the current market begin? · Weather risk management addresses the effect of changes in weather on enterprises and organizations. In its simplest form a party exposed to weather risk, definable in terms of a measurable weather element (e.g. temperature, precipitation) or combination of elements, pays a premium to a risk-taker. In exchange for the premium, the risk-taker, under pre-defined conditions based on an index constructed around the weather element(s), makes payment to the buyer in the event that given weather conditions prevail - i.e. that the currently measured weather element triggers payment provisions with respect to the weather index. The payment is pre-agreed and is based on the estimated or modelled impact of changes in weather on changes in the enterprise's revenues, margins or costs. Risk can be transferred in this way in the form of index-based insurance or in the form of physically-based derivatives. The use of insurance or derivatives is determined by regulatory factors and market preferences, differing from country to country and by business segment. At present, the weather risk market addresses general weather risk rather than extreme event (e.g. hurricane) weather risk such as found in the insurance-linked-securities market. · The current weather market is based on work done by Koch Industries, Willis and Enron and began with three transactions in the autumn of 1997 among, or intermediated by, these parties. Prior examples of weather based risk transfer, particularly in weather-contingent power, had been affected but remained stand-alone transactions which did not develop into a market. Presently, $30B - $40B of notional value is traded annually, according to surveys conducted by the Weather Risk Management Association. Exchange trading on the Chicago Mercantile Exchange, which the CME initiated in 1999, dominates these numbers. The figures also include a volume of over-the-counter transactions and of transactions on specific weather indices (particularly in Europe). The single greatest business segment engaged in weather risk is the energy/utility sector, but active interest in weather risk has broadened to include other sectors such as commodity trading, construction, agriculture, retail and leisure/entertainment. The WRMA data does not presently take up weather instruments sold in markets such as India, where thousands of small, parametric, weather risk insurance policies are sold to farmers, or in pilot projects managed by the World Bank, the World Food Program or NGOs. · The bulk of weather transactions involve North American risk, with meaningful activity also coming from Europe and Asia. Risk flows are increasing from Latin America and there also is activity in Africa. Weather risk instruments are used, inter alia, to manage utility exposure to weather, provide proxy cover for crop-yield, finance humanitarian relief, back-stop sales promotions, cushion the financial impact of weather-based interruptions on construction projects and manage sources of downside risk to investments in wind farms, hydroelectric facilities and other renewable-energy projects. 2. What advantages does involvement in the weather market hold for institutional investors? · Fundamentally the weather risk market is akin to the insurance-linked catastrophe risk market in that weather is not influenced by general financial markets. The weather, however, does influence certain segments of financial markets. At one level the weather risk market can act as a diversifier in an overall investment strategy. At another level, where a relationship between a given investment segment and weather exists, the weather risk market can be used to manage the exposures or to realize position's inherent value with respect to weather. · Methods of taking part in the market include: o Over-the-counter or exchange trading of specific exposures. o Providing risk capital to weather underwriters, which is being done by a number of hedge funds and insurers by means of investment, reinsurance or structures analogous to side-cars. o Anticipating the issue of weather-linked-securities, which, although not currently a market factor, are likely to be issued as the market expands, particularly with respect to national and regional agricultural risk. In the initial phases of the market Koch Industries issued a weather-risk bond (Kelvin) which primarily served as an auxiliary to its trading activity. · A major constraint in the weather risk business currently is that it is a growing market in a phase somewhat similar to the early stages of the credit or foreign exchange markets. One of the challenges at its present point of evolution is broad-based origination of original-end-user weather risk. 3. Who participates in the market? · Insurance companies, hedge funds, banks, energy companies and commodity traders are the major providers of risk capital in the market. They have different motivations for taking part. For some, the non-accumulative nature of weather risk allows them to assume risk efficiently on the basis of a marginal capital allocation. For others, the market represents an opportunity to manage weather exposures associated with specific proprietary transactions or to manage aggregate weather exposures (e.g. a portfolio of agricultural credits or accumulated long positions in energy) inherent to their business. The market also includes participants who seek to identify and realise value from movements in the market itself. |
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Articles of the same Serie : 101 |
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