Doing something about weather: weather derivatives have helped companies control financial risk for nearly a decade. Now that they're trading on a mercantile exchange, sales are really taking off.

Key Points

* New financial instruments that hedge weather risks dramatically spurred sales of weather derivatives last year.

* Large reinsurers and other financial institutions play a major role in creating weather derivatives.

* Trades on the CME may increasingly shift weather risk from insurance companies onto capital markets.

Everybody talks about the weather, but nobody does anything about it, as Mark Twain allegedly said. But that is no longer the case.

Today, experts from various disciplines have measured, commoditized and monetized the weather. The result has been a booming market the past year in weather derivatives, a risk-management product. And the implications are far-reaching.

Weather risk has always been a part of human activity. About a third of the American economy is affected by it, the U.S. Department of Commerce once estimated. Weather derivatives address the risks not of front-page, spectacular events such as hurricanes, but rather the slow, long-term effects of deviations from average temperatures or precipitation. These risks are of obvious interest to such companies as heating oil purveyors, power producers, farmers, construction firms and ski resorts, but more kinds of businesses are beginning to recognize the value of hedging against them.

The statistics speak volumes. In 2004, trade in weather derivatives totaled about $2.2 billion, according to the Chicago Mercantile Exchange. Last year, the figure exploded to more than $35 billion.

What is the allure? A heating oil dealer, for example, earns income through winter sales. If a winter is warmer than average, sales and profits drop. But the dealer may offset that risk by purchasing before winter a weather derivative that will pay a contractual amount depending on how much warmer than average the winter is. The derivative is made possible by companies that create the product framework, parties that invest in it, and brokers. The CME and other exchanges provide trading platforms, expertise and transparency. Reinsurers are significantly involved in underwriting, capitalizing and marketing derivatives.

"Firms that are managing their weather risk have been able to determine from a volumetric perspective, how much money they're making or losing based on where the temperatures are," said Felix Carabello, a director of the CME. "These companies are accessing the weather market to manage their risk, so what we're seeing is a greater acceptance of the idea and the instruments."

A Different Investment

Weather derivatives are attractive to investors because they offer a high degree of insulation from political and economic events. Many investors in weather derivatives manage hedge funds or pension funds that want an asset class uncorrelated to the regular investment markets. If they trade the commodities themselves, such as heating oil and natural gas, the prices are subject to outside events that have nothing to do with temperature, such as political developments in the Middle East or the Federal Reserve raising interest rates. "So what happens now is that fund managers and hedge funds are able to trade weather separate from any other type of risk that can come into play," said Carabello.

Contract prices on the CME are determined by multiplying a tick, which represents one heating degree day, by an index multiplier. Once a contract cost, or notional value, is established, buyers can determine how much they want to hedge a weather risk and how many contracts they need to buy. According to the CME, weather derivatives cover low-risk, high-probability events with standardized contracts, while weather insurance covers high-risk, low-probability events with customized con tracts. The CME sells temperature-based products in 18 U.S. cities, nine European cities and two Asian cities.

Significantly, many have come to consider the weather-derivatives market itself as the aggregate viewpoint of the forecast, said Carabello. In the past, a company that wanted to hedge would buy or sell oil or natural gas based on weather forecasts, but the weather market is becoming a leading indicator of the potential demand for the products. Now, if gas and oil prices are trading high and the derivatives market trades anticipate warmer temperatures, one knows there is a "disconnect," said Carabello. "If the higher prices are based on some kind of supply disruption, that's one thing, but if they're based on colder temperatures ... that disconnect doesn't last as long as it used to.

"It's our view that just buying a forecast is fine, but you need to take the extra step to manage that risk," he added. "Not doing so is like buying groceries and leaving them at the counter."

Valerie Cooper, executive director of the Weather Risk Management Association, a trade association, said the weather-derivatives industry has established itself as a provider of real risk-management tools. "It is here to stay, and it has enormous potential" she said. The great success of the CME in the last half of 2005 accounted for most of last year's growth, she noted, and she predicted significant growth this year.

Cooper said the first weather derivative probably appeared in 1997, though no one knows for sure. The largest so far may have been a five-year contract in the Netherlands worth about $500 million, she said. It hedged against construction workers being unable to work due to cold weather.

On Regulation, Prices

Weather derivatives are not considered insurance products in the United States, and they are regulated in different ways, if at all, depending on the country. Cooper said the National Association of Insurance Commissioners once considered whether weather risk management was better suited to be sold as insurance rather than as a derivative in the over-the-counter market, but the idea didn't fly because it was not a pure insurance product. "There's not really insurable interest," she said. "The risk of a company is the potential loss of revenue, not the plant catching fire."

Early weather derivatives were probably more expensive than today's. "Now there is a lot more transparency in the market, and a lot more liquidity," Cooper said. "That's due to the industry educating lots of business sectors. And sales have been fueled by the CME, where products have been very liquid and transparent. All of those contributing factors have brought down the prices."

Ironically, Enron was a big player in weather derivatives, and Cooper said its bankruptcy slowed the growth of the market. But many "very bright people" in the team at Enron subsequently went to other companies, she said. So Enron's demise "actually helped our industry, because new shops were opening up that were trading weather," she said.

Many of these people possessed the unusual skill-set combination useful in the weather-derivative business: a good financial background and a good understanding of the weather. "These two skill sets don't normally cross, particularly 10 years ago," said Cooper.

Barney Schauble, a principal at Bermuda-based Nephila Capital Ltd., said the energy industry was the first to quantify temperature and trade it as an instrument. Nephila, formerly Willis Asset Management, trades catastrophe bonds, insurance swaps and weather derivatives on behalf of institutional investors. Swaps are privately negotiated financial contracts in which two parties agree to exchange specific price risk exposures over an agreed-upon time.

The next group in were reinsurers such as Swiss Re, XL Capital and Ace, which typically called on large corporations that could use the product, Schauble said. Nephila offers several funds for institutional investors looking for an investment not correlated with the general financial marketplace. Its weather fund is called Nimbus.

Reinsurers' Major Role

One of the major market participants, Swiss Re, started in late 1998. The company, which runs the business out of offices in New York and Zurich, Switzerland, is most focused on selling structures, said Juerg Trueb, Swiss Re's weather-derivatives specialist. He estimated the company has about 20% of the market share worldwide. The product structures are based on anything related to precipitation, such as rainfall and snow depth, and wind speed. The energy sector contributes the most customers, followed by agriculture, transportation, construction and skiing. Contracts range in length from a month to as long as five years, he said. Many cover the winter season (November through March) or the summer season (May through September).

"We're one of the companies with the longest track records," said Trueb, who works out of Zurich. "We do this business worldwide, we like it, we're continuously expanding and deepening our relationships with clients, and we're getting more and more experienced."

The risks of writing the business are very case-dependent, Trueb said. With longer contracts, being right about the trend is very important "because the longer the contract goes, any kind of misrepresentation of the trend will feed directly into the economics," he said. "Then once you have gotten your hands around the risks related to a certain index, you can also have more or less risk depending upon how you set the strike levels. You can set the strike level such that the probability of a payout is relatively small, or you can obviously move the strike closer to the money, with an increase in chance to have a payout."

Swiss Re continuously monitors the valuations of its transactions. In liquid markets, the company performs daily valuations. If the markets are illiquid because the structures are highly customized for specific clients, the monitoring is more complicated, but the company uses methods to calculate the probability of a loss or expected losses, he said.

In contrast to securitizations such as catastrophe bonds, analysts do not rate weather derivatives. But companies that hedge with the derivatives may receive better credit ratings, Trueb said.

Looking Ahead

Snowfall derivatives are the latest in the evolution of the product. Carabello said the CME launched them in New York and Boston in February. The idea came up two years ago, when New York City Mayor Michael Bloomberg said removal of snow cost the city about $1 million per inch. "The past three years, New York has had some pretty bad winters to the extent that it used up its snowfall budgets early in the season," said Carabello. "They had to go into other budgets to remove the snow, and those budgets were being strained. And now we're looking at other types of event risks, even things like hurricanes and evacuation risks. We're looking at events and risks to the economy that right now are very difficult to manage."

Among instruments to address such big risks are those that insurance companies can use to transfer some of that risk off their balance sheets, and potentially outside of that insurance space altogether, said Carabello. His view is that catastrophic risks are too concentrated with reinsurers. The new instruments would not pose threats to the insurance business, but would augment it and add to insurers' arsenals of products, he said.

"You can see where it's going," said Carabello. "It's really redefining how reinsurance companies will be able to underwrite policies and provide insurance to various regions of the country. The number of hurricanes is going up, the magnitude of damages is also going up, and you can either manage risk by leaving the business, or mitigate it or manage it through some kind of financial instrument."

The new tools also may influence how companies are expected to execute their fiduciary responsibility to manage risk. "There is greater acceptance that companies have weather risk in their portfolios," he said. "Now the financial community is less accepting of the argument that there's nothing you can do to manage that risk."

No longer will companies be able to say they had banner years because the weather was good or lean years because the weather was bad, said Carabello. Instead, analysts will view failure to address weather risk as an acceptance of earnings volatility, which would drive up borrowing costs.

Carabello said the exchange is probably "in the top of the first inning" in measuring, commoditizing and monetizing risks. "We're talking about building a marketplace from the ground up," he said. "It takes time, which is exactly what we did with weather."

Reinsurance companies have played a huge role, he said. "They were on the leading edge, and they're still on the leading edge in the development of these products. They're still involved in this industry."

Weather extremes fuel interest in weather derivatives.

Mega-hurricanes have caused insurers and public policymakers to reassess catastrophe strategies. In a similar way, business leaders may be reassessing the more insidious risks of global warming.

Warmer-than-normal winters, for example, erode sales by utility companies and cause them to consider hedging those risks, said Valerie Cooper, executive director of the Weather Risk Management Association, on a 70-degree January day in Chicago.

But the issue may not be that simple, according to Juerg Trueb, a Swiss Re specialist in weather derivatives. He said he often sees trends in temperature tendencies and takes those trends into account when pricing weather transactions. Companies, however, react to extreme weather events that lead to financial losses, not to global warming. "Most of the companies are not aware of the impact of a kind of smooth and relatively slow change in the average temperature," he said. "They are all reacting to extreme fluctuations."

Barney Schauble, a principal of Nephila Capital Ltd., which trades several kinds of weather products on behalf of institutional clients, agreed that if every winter is warmer than the previous one, it would impact pricing. But the global warming trend doesn't show up every year in every city of the world. "We think about trends in every major city quite carefully," he said.

Felix Carabello, a director at the Chicago Mercantile Exchange, said global warming has nothing to do with activity there. "I talk to meteorologists who say there is global warming, and others who say there isn't," he said. "I don't know. But to say that global warming is driving the activity at the Mere is wrong. One has nothing to do with the other. We're coming up with financial applications."

Learn More

Swiss Re Group A.M. Best Company # 85010 Distribution: Reinsurance brokers For ratings and other financial strength information about this company, visit www.arnbest.com.

Weather Derivative Trades Going Up

Increase of
257,936%

   1999           2005

336 trades   867,000 trades

2006
(Through Feb. 16)

168,000 trades

How Temperature
Products Work

Temperature products traded at the
Chicago Mercantile Exchange have
the following characteristics:

* Quantify weather in terms of degrees above or
below monthly or seasonal average temperatures.

* Attach a dollar amount to the number of
degrees a month's or season's temperature
deviates from an average value, based on a
specific index.

* Are settled in cash based on the final monthly
or seasonal index value determined for each
contract by Earth Satellite Corp.

CME Average Daily Volume,
Weather Derivative Trades

2004     377
2005   3,500
2006   6,500

Note: Table made from bar graph.

Source: Chicago Mercantile Exchange