In 1997 three transactions involving Willis, Koch Industries, and Enron marked the beginning of a new way of managing weather risk. Their work focused on the use of weather data (measurable weather variables such as temperature or precipitation) as the basis for risk indices, which turned out to be the key for making weather risk fungible. This approach of expressing and transferring risk in terms of temperature, precipitation, snowfall, wind or other measurable variables has attributed greatly to today’s current weather risk market.
How Does Weather Risk Management Work?
The principle is easy to illustrate. In a typical temperature transaction, if weather is too warm – i.e. the average temperature measured over a defined period exceeds a pre-agreed threshold – the buyer is entitled to receive a payment from the seller based on the extent to which the average temperature exceeded the threshold. The amount of payment is determined in advance in accordance with the buyer’s sensitivity to adverse changes in temperature.
In the current weather market, risks can be transferred in this manner in the form of index-based insurances and through derivative transactions built on similar weather indices. Please refer to the “Weather Risk” section of this website for a more in-depth discussion of weather risk management and the business of weather risk.
In and of itself there was nothing new in the idea of transferring weather risk. Weather has been the subject of insurance and risk-mitigation for some time:
- Drought insurance
- Hail insurance, Etc.
- Public events, such as sporting events or concerts
- Sales promotions (i.e. a $1,000 rebate on your car if it snows on New Year’s Eve)
Contingent Power Supply Agreements
- Pooling temperature risk through a gas-utility mutual
Yet these predecessor transactions and initiatives each had their limitations and none developed into a market. The weather risk market Distinguishes itself by combining several features:
- Provides index-based risk transfer per measurable weather variables.
- Factors in temperature, precipitation, snowfall, stream flow, wind speed, daylight hours, humidity and other weather variables.
- Transfers risk on the basis of several different measures:
– Aggregate measures, like the total precipitation in a period or total degree days in a period
– Frequency of incidence, such as the number of days with a maximum temperature less than 32ºF during a given period
– Adverse event, for example a rainfall greater than 0.50 cm on the day of the finals at Wimbledon) per closely related methodologies which integrate the market.
- Manages risk in ways compatible with both financial and insurance markets.
- Comprises a primary and secondary market in weather risk.
The weather market has experienced rapid evolution in its short history. Significant El Nino Southern Oscillator (ENSO) events hallmarked its first two winters, during which the young market was dominated by warm side winter risk, particularly gas utilities seeking protection from the consequences to their revenues of warm winters on volumes of gas purchased by consumers. The risk was held by risk takers (predominantly insurance companies) who, in the main, managed their risk geographically under a buy and hold regime. Particularly the first winter season’s El Niño event not only pushed temperatures against those holding risk in the market, it also made the weather pronouncedly directional across the U. S., destroying the fundamental assumptions of the market’s geographical risk management practices. The surviving risk takers changed their approach, choosing to manage risk dynamically according to disciplines adapted from commodity and financial trading. Energy and utility corporations’ trading operations became increasingly active in the market until the crisis in the energy sector in 2001-2002. The place of the energy traders has been taken by insurers, banks and hedge funds and by trading on exchanges, preeminently on the Chicago Mercantile Exchange. This constellation of market makers and market participants today (2006) offers the weather market greater depth, breadth and financial security than ever. Its numbers include several of the strongest financial institutions on the globe.
Since its start, the weather market has expanded geographically, with weather business being transacted on risks from all inhabited continents, most particularly North America, Japan and Europe. Emerging from a period in which the market was dominated by energy business, the market is spreading to encompass a variety of sectors, including agriculture, construction, transportation and entertainment. In recent years the exchange trading of weather risk, often in conjunction with commodity and energy risk, has mushroomed and has attained a level of critical mass on the CME. The weather market has emerged as an important contributor to the management of risk in a wide variety of businesses and areas of government responsibility.
We expect the weather market to continue to develop, broadening its scope in terms of geography, client base and interrelationship with other financial and insurance markets. Although the weather risk market has made a very good start, there remains plenty of space in which it can grow even further and contribute to the management of a complex of risk which affects a third or more of the world’s GDP.