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INDEX OF WEATHER
Research Paper - Weather Risk Management Solutions, weather insurance and weather derivatives
Author: Jerry Lettre, Rivier College Lins to source: http://members.aol.com/gml1000/wrms.htm Like Like

Introduction Weather affects everyone. In fact, weather is so intertwined with our life that it directly affects 20% of the economy.1 It is estimated that up to 70% of all businesses face weather risk of some sort 2 and businesses in the United States are impacted to the tune of $200 billion per year.3 Weather risk management is a new process that many businesses can take advantage of to manage the effect weather can have on revenue and expenses. These weather risk management tools are weather insurance and weather derivatives. This paper will outline weather risk management solutions, discuss the options available and the risk-return aspects of the subject.

Overview When it comes to a weather forecast, a business can generally take the information and use it to mitigate losses or determine whether or not to spend the money for a particular event. A weather forecast can help one make better decisions. In addition, many businesses are also affected by what happens during a season. A warmer than normal winter or a cooler than normal summer can impact all sorts of companies like utilities, food and agricultural groups and even retailers. Scientists have been researching the possibility of seasonal climate forecasting in earnest since the El Nino episode of 1982. Large strides have been made in this endeavor with government and private forecasting groups producing seasonal forecasts with varying levels of sophistication.4 In addition, in recent years, many financial and insurance services groups have developed various financial tools to help businesses manage weather risk. These tools include weather insurance and weather derivatives. Each product has its place and in many ways they are similar. Weather derivatives seems to getting more of the attention. This is mainly due to the level of sophistication of the sellers and the buyers of weather derivatives. In fact, the Weather Risk Management Association5 was formed to address and assess the issues that face the weather derivatives "industry". Its members consist of buyers and sellers of the derivatives and long range forecasting groups.

Weather Insurance Weather insurance is a creative product that can be used for situations ranging from sales promotions to income stabilization. Unlike regular insurance, which would only cover physical damage, weather insurance protects against additional expenses or loss of profit stemming from a specific weather event.6 Weather insurance tends to cover high-risk, lower probability events while weather derivatives protect against lower risk, higher probability events.7 High risk, lower probability events include hurricanes, snowfall exceeding criteria limits on certain days, rained-out events, etc. Lower-risk, high-probability events include cool summers and warm winters, which can affect revenues, expenses and cash flows for businesses of all types. Insurance generally pays based on actual damages, while derivatives pay based on the difference between a negotiated "strike price" and the actual weather (or the total of weather related index).8 Weather insurance companies market weather insurance to meet specific situations. Examples of insurance uses are as varied as the customer base for these products. For instance, many businesses depend on having business on specific days of the week. Strong business on a Saturday can be critical to the profitability of a business like a restaurant. During the winter, a snowstorm on a Saturday cuts deeply into the profits and cash flow of the restaurant. For our example, a restaurant in Portland, ME purchased weather insurance to hedge against the possibility of more than 3.5 inches of snow on any Saturday from December through April. The restaurant pays an insurance premium of $9240 for this coverage. On each Saturday, when more than 3.5 inches of snow fell, the restaurant ends up receiving $7500 from the insurance company. The budgeted premium and insurance coverage stabilizes the business income for the season.9 Some businesses use weather insurance for more creative purposes. For instance, a clothing store in Little Rock, AR ran an interesting promotion. Their promotion stated "if two inches or more of snow falls on Christmas, you get your money back on all your purchases made between November 24 and December 18". The clothing store paid $6875 for $250,000 worth of coverage.10 It is a relatively safe bet that the insurance company did not have make good on it coverage. At the same time, it's likely the clothing store made a good marketing investment. The risk for the clothing company is the cost of the insurance and it is considered part of the promotional expense.

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Weather Derivatives Weather derivatives are a relatively new product for businesses to hedge the effects weather can have on operations. Weather derivatives can be complicated, very involved and hard to understand. A weather derivative is a financial instrument that has a payoff derived from one or more independently measurable weather factor(s) like temperature, snow depth and many others.11 Weather derivatives shield revenues against lower risk, higher-probability events like a mild winter. Hedging, by definition, is a means to engage in a transaction that partially or fully reduces a prior risk exposure.12 The first weather derivative was issued in August 1996. It is now estimated that $2 to $3 billion worth of weather hedges are sold worldwide.13 The Chicago Mercantile Exchange pioneered offering heating degree-day and cooling degree-day futures and options as the first exchange-traded, temperature-related weather derivatives.14 Weather derivatives are also traded at I-wex.com (and sponsored by the London International Financial Futures and Options Exchange) which was launched in January 2000.15 Other Internet sites are coming on line while other large exchanges are analyzing the weather derivative market for themselves.16 Whatever the weather measurement is, weather derivatives are handled like futures and options. Terms like swaps, short, long, put options, call options, floors, caps, strike points are used with these products. Let's define some of these terms Swaps are privately negotiated financial contracts in which two parties agree to exchange or "swap" specific price risk exposures over a predetermined period of time.17 Swaps are similar to buying or selling futures where two different parties take opposite sides of a strike point on a predetermined index. The contract is usually settled in cash. The general notion of a long (or buy) position is that profits are made when prices increase and losses occur when prices decrease. With a short (or sell) position, profits occur when prices decrease and losses occur when prices increase.18 Caps and floors are options that provide the right, but not the obligation, to enter into a long or short position at a specific price. The purchaser of a cap or floor pays an up-front cash premium for price protection. With the cap (also known as call options) and floors (referred to sometimes as put options) all risks are predefined. The premium paid for a cap or floor is the maximum loss or cost incurred by the purchaser. Caps are used to establish a maximum price (against an index price). They are used to provide protection from rising prices. Floors on the other hand, establish a minimum price and help protect from falling prices. By purchasing a cap or floor the business lowers the risk to adverse price movements, but still is able to take advantage of beneficial price moves.19 Lastly, strike point is the place in the option contract that sets the level for payouts. As an investor, being involved in weather derivatives is attractive because weather risk is not correlated with other market sectors. There is a risk of losing or making a significant amount of money with derivatives. This is why the strike point is very important. In most cases, weather derivatives are structured to minimize liabilities. Some examples One type of business that is seriously dependent on the weather is the recreational skiing industry. A ski resort can suffer greatly from warm temperatures, temperatures that are too cold, lack of natural snow, temperature conditions that aren't right for making snow, or too much snow. The weather occurring during the winter for a ski resort can mean the difference between making a worthwhile profit or losing a significant amount of money. There are many different weather derivative options available to help ski resorts weather the winter season. In addition, many weather derivative companies are willing to do custom contracts.20 One such custom option is a put option. A resort would purchase a put option. The contract would be set up for a set period of time (January through April). Every option sold has a counterparty (a group that takes the other position). Since this is a put option, the ski resort would pay a nonrefundable premium. For our example, this premium to the ski resort would be about $300,000. The strike point would be 80 inches. If snowfall totals for the 4 months is less than the strike point or predetermined, contracted level then the ski resort would be paid a certain number of dollars per inch of deficit. A snowfall total less than 80 inches pays $100,000 per inch (in most cases, a maximum payout limit would be set). If more than the 80 inches is recorded, then the ski resort does not receive any funds or a refund of the $300,000 premium. This option is very much like an insurance policy, but with several differences.21 The main difference...the credit approval process for derivatives of any kind is very stringent and detailed. Margin, also know as a good faith deposit, is required.22 Another popular contract is the swap. There is no premium with a swap. The swap involves the ski resort and a counterparty. In a nutshell, if the snowfall amount is normal, neither party receives payment. Sometimes this "normal range" is expanded with something called a collar. Instead of a strike point of 100, the normal range would be 95 to 105. For our next example, let's say the strike point is 100 inches of snow (with no collar). If the snow amount were less than 100 inches, then the counterparty would pay $100,000 per inch below 100 inches to the resort. Conversely, if the snow amount was greater than 100 inches, then the ski resort would owe the counterparty $100,000 per inch. This kind of swap allows the ski resort to hedge against revenue losses, while the swap is financed by the high revenues from the ski resort when seasonal amounts of snow are over 100 inches. Another alternative is a little creative, but has beneficial outcomes to the ski resort. In this case, the ski resort writes a call option. The resort receives a premium from the counterparty and pays out only when the snowfall exceeds a certain level. In this case, the resort receives a steady income (the premium), and can afford to pay the contract off when more snow is received because the resort has planned on having the payout funds available due to increased revenues.23 Weather derivatives can offer the benefit of stabilizing income and at the same time eliminate the effects that weather extremes can have on a business. There are many other instances on how weather risk management can be dealt with using weather derivatives. Another example features a fuel oil company, which uses weather derivatives to protect the operation of its business. In this case, the weather derivatives are based on heating degree-days. A degree-day is a measure of a day's average temperature and its difference from 65 degrees Fahrenheit. If the average daily temperature were 45 (average of high of 55 and low of 35), then the heating degree-days for that date were 20. These heating degree-days are accumulated over a season and can be used to determine how cold a season was. A similar process is available during the summer, but the index is called cooling degree-days.24 In our example, the business determined that it lost money if the heating degree-days were less than 4750, when the weather was too warm for the season and therefore there were not enough revenues to cover overhead. If the heating degree-days were greater than 6050, the weather was too cold and they had to purchase more expensive fuel on the spot market. The company (in this case) purchases a swap, which protects the business if the weather is warmer than expected. But what if the weather is much colder than normal and the fuel company wants to protect its assets from this extreme. The fuel company purchases a call or a cap. They paid a premium for the call, but they got protection from paying out too much if the winter was colder than normal and especially if the heating degree-days were greater than 6050 for the

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season.25 All these new tools are fine, but who is using them? Several companies using derivatives also sell them. Some of the derivative companies happen to be owned by large energy companies. An aggressive seller of weather risk management tools is Aquila Energy. This company is a leading power and natural gas wholesaler, and risk management company in the United States.26 Other energy companies use weather insurance to protect their business. Nicor in Naperville, IL stated the following in a press release dated April 18, 2000: Although weather was 10% warmer than last year, its adverse effect on operating results was partially mitigated by the company's weather insurance, which protects earnings to the extent that weather is more than 6.5% warmer than normal.27

Conclusion Clearly, weather insurance and weather derivatives offer opportunities for weather sensitive businesses, insurance companies, sellers of weather derivatives, and weather/climate forecasting companies. There are several challenges facing this industry. One issue is communicating and marketing the advantages of these products while making it easy to understand. Another concern is seasonal climate forecasts. These forecasts will only improve over the next 5 to 10 years and become very valuable. Aquila Energy, one of the providers of weather derivatives, is betting on it. It is running a seasonal climate forecast contest that awards $50,000 for the best forecast for each winter and summer season of the next 4 years.28 Currently, weather derivatives and weather insurance vendors appear skeptical about using seasonal climate forecasts for incorporation into the contracts. Ironically, perception of what will happen (like a warmer than normal winter), already affects the strike points much like perception of future expectations affects prices in the stock market. As the forecasts improve, weather insurance and weather derivatives will be optimized for buyers and sellers of these products. It is clear to see that the future looks bright for these new financial and insurance products. Even better, with proper use of these products, businesses and our economy will only benefit. Endnotes 1 http://www.cme.com/weather/weather.html 2 http://www.weatherriskadvisory.com/weather.htm 3 Advance Forecasting Corporation. Crossing New Thresholds in Weather. http://www.tradeweather.com/ 4 http://www.cme.com/weather/introweather.html 5 http://www.wrma.org/ 6 http://www.goodweather.net/goodweather.income.html 7 http://www.weatherriskadvisory.com/weather.htm 8 Aquila Energy. Aquila Energy Goes Online with Weather-Risk Management Portal. http://www.guaranteedweather.com/ 9 http://www.goodweather.net/goodweather/income.html 10 http://www.goodweather.net/goodweather/income.html 11 http://www.weatherriskadvisory.com/weather.htm 12 Stanley B. Block and Geoffrey A. Hirt. Foundations of Financial Management (Boston: Irwin McGraw-Hill, 2000), 225. 13 Aquila Energy. Add One Aquila e-business. http://www.guaranteedweather.com/ 14 www.cme.com/weather/weather.html 15 Aquila Energy. Aquila Long-Range Forecast Comparison Overview. http://www.guaranteedweather.com/ 16 http://www.weatherriskadvisory.com/weather.htm 17 http://www.wrma.org/what/whattext.htm 18 Stewart L. Brown and Steve Errera. Trading Energy Futures (New York: Quorum Books, 1987), 9. 19 http://www.wrma.org/what/whattext.htm 20 Aquila Energy. Aquila Energy Goes Online with Weather-Risk Management Portal. http://www.guaranteedweather.com/ 21 Aquila Energy. Weather Risk Management for Ski Resorts. http://www.guaranteedweather.com/ 22 Todd Lofton. Getting Started in Futures (New York: John Wiley & Sons, 1989), 39 23 Aquila Energy. Weather Risk Management for Ski Resorts. http://www.guaranteedweather.com/ 24 http://www.cme.com/weather/weather.html 25 http://www.cme.com/weather/risk.html 26 Aquila Energy. Aquila Energy Goes Online with Weather-Risk Management Portal. http://www.guaranteedweather.com/ 27 Nicor Incorporated, "Nicor Reports First Quarter 2000 Earnings," Bloomberg.com, 18 April 2000.

Bibliography Advance Forecasting Corporation. Crossing New Thresholds in Weather. http://www.tradeweather.com/ Aquila Energy. Add One Aquila e-business. http://www.guaranteedweather.com/

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Aquila Energy. Aquila Energy Goes Online with Weather-Risk Management Portal. http://www.guaranteedweather.com/ Aquila Energy. Aquila Long-Range Forecast Comparison Overview. http://www.guaranteedweather.com/ Aquila Energy. Weather Risk Management for Ski Resorts. http://www.guaranteedweather.com/ http://www.cme.com/weather/introweather.html http://www.cme.com/weather/weather.html http://www.cme.com/weather/risk.html http://www.goodweather.net/goodweather.income.html http://www.weatherriskadvisory.com/weather.htm http://www.wrma.org/ http://www.wrma.org/what/whattext.htm Nicor Incorporated, "Nicor Reports First Quarter 2000 Earnings," Bloomberg.com, 18 April 2000. Stanley B. Block and Geoffrey A. Hirt. Foundations of Financial Management (Boston: Irwin McGraw-Hill, 2000), 225. Stewart L. Brown and Steve Errera. Trading Energy Futures (New York: Quorum Books, 1987), 9. Todd Lofton. Getting Started in Futures (New York: John Wiley & Sons, 1989), 39
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