Weather risk management
Encyclopedia
Weather risk management is a type of risk management
done by organizations to address potential financial losses caused by unusual weather.
.
The weather risk market makes it possible to manage the financial impact of weather through risk transfer instruments based on a defined weather element, such as temperature, rain, snow, wind, etc. Weather risk management is a way for organizations to limit their financial exposure to disruptive weather events. By making a payment (a "premium") to a separate company that will assume the financial weather risk for them, an organization essentially is buying a type of insurance - the company assuming the risk will pay the buyer a pre-set amount of money which will correspond to the loss or cost increase caused by the disruptive weather.
Catastrophic weather events such as hurricanes are typically managed through traditional insurance contracts that pay based on indemnity loss. Insurance is a heavily regulated industry with specific requirements and qualification criteria. Due to the indemnity nature of insurance, actual loss must be proven to an insurance carrier before the payment can be processed. In contrast, financial loss such as erosion of margin, portfolio loss or increased expenses usually do not qualify for insurance payouts. Financial instruments such as derivative transactions can provide more flexible and customized risk management opportunities than the typical insurance contracts as they are priced and settled on the parameters of measured weather rather than the associated financial loss.
(OTC) or on commodity exchanges such as The Chicago Mercantile Exchange
(CME). Still other operations, such as Storm Exchange, Inc
and WeatherBill
, provide corporate and municipal clients with the necessary financial context to gauge the impact of the weather on profit and loss before executing trades either OTC or through the CME.
, Section 5d establishes weather in a category of market exempt from Commission oversight.
Rule 36.2 defines those commodities that are eligible to trade on an exempt board of trade as commodities having:
The Commodity Futures Trading Commission
determined that weather indices are eligible to be traded on EBOTs by order dated May 30, 2002.
: For U.S. accounting standards, Over-the-Counter (OTC) weather derivative transactions can generally get an exemption under derivatives & hedging disclosure rules of Financial Accounting Standard No. 133 section 10 for non-exchange contracts settled on climatic variables, although specific structures and applications have to be assessed for each company environment. All written non–exchanged–traded option–based weather derivatives
contracts should be carried at fair value with subsequent changes in fair value reported in current earnings.
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
done by organizations to address potential financial losses caused by unusual weather.
Overview
Energy, agriculture, transportation, construction, municipalities, school districts, travel, food processors, retail sales and real estate are all examples of industries whose operations and profits can be significantly affected by the weather. For example, unusually mild winters diminish consumer demand for heating and erode the profit margins for utility companies. Unexpected weather events can cause significant financial losses. Weather information and forecasts utilized in risk management decision making is often referred to as meteorological intelligenceMeteorological intelligence
Meteorological intelligence is information measured, gathered, compiled, exploited, analyzed and disseminated by meteorologists, climatologists and hydrologists to characterize the current state and/or predict the future state of the atmosphere at a given location and time...
.
The weather risk market makes it possible to manage the financial impact of weather through risk transfer instruments based on a defined weather element, such as temperature, rain, snow, wind, etc. Weather risk management is a way for organizations to limit their financial exposure to disruptive weather events. By making a payment (a "premium") to a separate company that will assume the financial weather risk for them, an organization essentially is buying a type of insurance - the company assuming the risk will pay the buyer a pre-set amount of money which will correspond to the loss or cost increase caused by the disruptive weather.
Catastrophic weather events such as hurricanes are typically managed through traditional insurance contracts that pay based on indemnity loss. Insurance is a heavily regulated industry with specific requirements and qualification criteria. Due to the indemnity nature of insurance, actual loss must be proven to an insurance carrier before the payment can be processed. In contrast, financial loss such as erosion of margin, portfolio loss or increased expenses usually do not qualify for insurance payouts. Financial instruments such as derivative transactions can provide more flexible and customized risk management opportunities than the typical insurance contracts as they are priced and settled on the parameters of measured weather rather than the associated financial loss.
Market participants
A wide range of capital providers make markets in weather risk. To date the weather risk management trading market is primarily made up of dedicated weather trading operations, such as Nephila Capital Ltd, Galileo Weather Risk Management Advisors LCC, Swiss Re, RenRe, and Coriolis Capital, who execute trade orders in weather or weather-contingent commodity trades, the trading desks of financial institutions and utilities, such as Susquahanna Energy and Aquila who hedge their own risk as well as speculative trades for a merchant portfolio, professional commodity traders, such as RJO and hedge and private equity funds such as Tudor Capital. Transactions can be effected over-the-counterOver-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC) or on commodity exchanges such as The Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
(CME). Still other operations, such as Storm Exchange, Inc
Storm Exchange
Storm Exchange, Inc. is a publisher of weather intelligence for business that was founded in 2006. The Company is headquartered in New York City and operates a weather research center in State College, PA....
and WeatherBill
Weatherbill
WeatherBill is an online service, launched in January 2007, that helps people and businesses adapt to climate change. The company’s technology platform enables the real-time pricing and purchasing of customizable weather insurance using proprietary global weather simulation modeling and local...
, provide corporate and municipal clients with the necessary financial context to gauge the impact of the weather on profit and loss before executing trades either OTC or through the CME.
United States
In the US, the Commodity Exchange ActCommodity Exchange Act
Commodity Exchange Act is a federal act passed in 1936 by the U.S. Government ....
, Section 5d establishes weather in a category of market exempt from Commission oversight.
Rule 36.2 defines those commodities that are eligible to trade on an exempt board of trade as commodities having:
- A nearly inexhaustible deliverable supply;
- A deliverable supply that is sufficiently large, and a cash market sufficiently liquid, to render any contract traded on the commodity highly unlikely to be susceptible to the threat of manipulation;
- No cash market.
The Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
determined that weather indices are eligible to be traded on EBOTs by order dated May 30, 2002.
Accounting for OTC weather derivatives as a hedge
Companies that are subject to public disclosure to regulators or their shareholders must demonstrate that the purchase or a sale of a derivatives is true and fair hedge, not speculation. SFAS 133 and IAS provide guidelines on the steps that are required. FAS 133 Accounting for Weather DerivativesWeather derivatives
Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions...
: For U.S. accounting standards, Over-the-Counter (OTC) weather derivative transactions can generally get an exemption under derivatives & hedging disclosure rules of Financial Accounting Standard No. 133 section 10 for non-exchange contracts settled on climatic variables, although specific structures and applications have to be assessed for each company environment. All written non–exchanged–traded option–based weather derivatives
Weather derivatives
Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions...
contracts should be carried at fair value with subsequent changes in fair value reported in current earnings.
Accounting for Exchange traded and speculative weather derivatives
When they are standardized and traded on exchanges, weather derivatives will fall within the scope of SFAS 133. EITF Issue No 99–2 "Accounting for weather derivatives" provides guidance on accounting for weather derivatives that are not exchange–traded. Entities that enter into speculatives or trading non–exchange derivatives contracts should apply the intrinsic method.Further reading
- Considine, G., 2000, "Introduction to Weather Derivatives", Weather Derivatives Group, Aquila Energy.
- Peter Robison, "Funds raise interest in weather futures", Bloomberg News, August 2, 2007.
- USA Today (2008), "Weather Derivatives becoming hot commodities", USA Today Online posted 6/9/2008.
- Alice Gomstyn, Rich Blake and Dalia Fahmy, "Want a Weather Forecast? Ask Wall Street" ABC News, February 8, 2010.
- Dischel, R. S., Ed. (2002). "Climate Risk and the Weather Market: Financial Risk Management with Weather Hedges", Risk Books.
- Jewson, S., A. Brix and C. Ziehmann (2005). "Weather Derivatives Valuation: The Meteorological, Statistical, Financial and Mathematical Foundations". Cambridge, Cambridge University Press.
- Golden, L. L., M. Wang and C. C. Yang "Handling Weather Related Risks Through the Financial Markets: Considerations of Credit Risk, Basis Risk, and Hedging." Journal of Risk & Insurance, Vol. 74, No. 2, pp. 319–346, June 2007.
- Myers, R. (2008) "What Every CFO Needs to Know About Weather Risk Management", Storm Exchange, Inc. & CME Group
- Mathews, J. S. (2009) "Dog Days and Degree Days", CME Group
- Tang, K., Ed. (2010). "Weather Risk Management: A guide for Corporations, Hedge Funds and Investors", Risk Books.
External links
- Weather Products at Chicago Mercantile Exchange
- Weather Risk Management Association (WRMA)
- Weather Risk links collection
- Weather Derivatives and Weather Risk Professionals Group
- Weather Risk Management Option with the Meteorology Undergraduate Programme at Penn State
- Weather risk management and risk transfer news and research from Artemis.bm
See also
- Weather DerivativesWeather derivativesWeather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions...
- Alternative Risk TransferAlternative Risk TransferAlternative Risk Transfer is the use of techniques other than traditional insurance and reinsurance to provide risk bearing entities with coverage or protection...
- WindScanWindScanWindScan contains globally gridded, high resolution offshore wind speeds and directions on a 0.250 global grid and multiple time resolutions down to 6 hourly measurements...
- CelsiusProCelsiusProCelsiusPro AG is a Swiss company specialized in structuring and originating OTC weather derivatives worldwide. Using a proprietary platform, CelsiusPro enables online price calculation, execution and position reporting as well as weather statistics and analysis...