Alternative Risk Transfer and the Weather Market Dr Harvey Stern, Bureau of Meteorology, Australia

Outline of Presentation Alternative Risk Transfer (ART). - definition The Weather Market. - current status Channels for Weather Risk Transfer. - securitisation - catastrophe bonds - weather derivatives

Background Weather risk is one of the biggest uncertainties facing business. We get droughts, floods, fire, cyclones (hurricanes), snow & ice. Nevertheless, economic adversity is not restricted to disaster conditions. A mild winter ruins a skiing season, dry weather reduces crop yields, & rain shuts-down entertainment & construction.

Weather & Climate Forecasts Daily weather forecasts may be used to manage short-term risk (e.g. pouring concrete). Seasonal climate forecasts may be used to manage risk associated with long-term activities (e.g. sowing crops). Forecasts are based on a combination of solutions to the equations of physics, and some statistical techniques. With the focus upon managing risk, the forecasts are increasingly being couched in probabilistic terms.

Industry Risk "Shares in Harvey Norman fell almost 4 per cent yesterday as a cool summer and a warm start to winter cut into sales growth at the furniture and electrical retailer's outlets… Investors were expecting better and marked the shares down 3.8 per cent to a low of $3.55… Sales at Harvey Norman were hit on two fronts. Firstly, air conditioning sales were weak because the cool summer, and a warmer than usual start to winter had dampened demand for heating appliances”. Source: The Australian of 18 April, 2002

Agricultural Risk “The Australian sugar industry is facing its fifth difficult year in a row with a drought dashing hopes of an improved crop in Queensland, where 95% of Australia's sugar is grown... Whilst dry weather during the May-December harvest period is ideal for cane, wet weather during this time causes the mature cane to produce more shoots and leaves, reducing its overall sugar content”. Source: Australian Financial Review of 8 May, 2002

Should Companies Worry? In the good years, companies make big profits. In the bad years, companies make losses. - Doesn’t it all balance out? - No. it doesn’t. Companies whose earnings fluctuate wildly receive unsympathetic hearings from banks and potential investors.

What is ART? ART (Alternative Risk Transfer) is a generic phrase used to denote various non-traditional forms of re/insurance and techniques where risk is transferred to the capital markets. Source: http://www.artemis.bm

Why has ART grown? Risk management moving up the agenda A need to manage uninsurable liabilities A need to protect against irregular income “spikes” Source: Modern ART practice (Gerling Global Financial Products)

What is the future of ART? “The term Alternative Risk Transfer (ART) will soon be a misnomer. ART is fast becoming an essential risk management tool for primary insurers, reinsurers and non-insurance corporations”. Source: Modern ART practice (Gerling Global Financial Products)

The Weather Market - Growth. 3,937 contracts transacted in last 12 months (up 43% compared to previous year). Notional value of over $4.3 billion dollars (up 72%). Market dominated by US (2,712 contracts), but growth in the past year is especially so in Europe and Asia. Australian market accounts for 15 contracts worth over $25 million (6 contracts worth over $2 million, previously). Source: Weather Risk Management Association Annual Survey (2002)

The Weather Market - Diversification. Another significant development is the diversification of the types of contracts that were transacted. Temperature-related protection (for heat and cold) continues to be the most prevalent, making up over 82 percent of all contracts (92% last year) Rain-related contracts account for 6.9% (1.6% last year), snow for 2.2% (0.6% last year) and wind for 0.4% (0.3% last year). Source: Weather Risk Management Association Annual Survey (2002)

Weather-linked Securities Weather-linked securities have prices which are linked to the historical weather in a region. They provide returns related to weather observed in the region subsequent to their purchase. They therefore may be used to help firms hedge against weather related risk. They also may be used to help speculators monetise their view of likely weather patterns.

Securitisation The reinsurance industry experienced several catastrophic events during the late 1980s & early 1990s. The ensuing industry restructuring saw the creation of new risk-management tools. These tools included securitisation of insurance risks (including weather-related risks). Weather securitisation may be defined as the conversion of the abstract concept of weather risk into packages of securities. These may be sold as income-yielding structured products.

Catastrophe Bonds A catastrophe (cat) bond is an exchange of principal for periodic coupon payments wherein the payment of the coupon and/or the return of the principal of the bond is linked to the occurrence of a specified catastrophic event. The coupon is given to the investor upfront, who posts the notional amount of the bond in an account. If there is an event, investors may lose a portion of (or their entire) principal. If there is no event, investors preserve their principal and earn the coupon. Source: Canter & Cole at http://www.cnare.com

Catastrophe Swaps A catastrophe (cat) swap is an alternative structure, but returns are still linked to the occurrence of an event. However, with swaps, there is no exchange of principal. The coupon is still given to the investor upfront, but the structure enables investors to invest the notional amount of the bond in a manner of his own choosing. Source: Canter & Cole at http://www.cnare.com

Weather Derivatives Weather derivatives are similar to conventional financial derivatives. The basic difference lies in the underlying variables that determine the pay-offs. These underlying variables include temperature, precipitation, wind, and heating (& cooling) degree days.

An Early Example In 1992, the present author explored a methodology to assess the risk of climate change. Option pricing theory was used to value instruments that might apply to temperature fluctuations and long-term trends. The methodology provided a tool to cost the risk faced (both risk on a global scale, and risk on a company specific scale). Such securities could be used to help firms hedge against risk related to climate change.

A Weather-linked Option An example of a weather linked option is the Cooling Degree Day (CDD) Call Option. Total CDDs is defined as the accumulated number of degrees the daily mean temperature is above a base figure. This is a measure of the requirement for cooling. If accumulated CDDs exceed “the strike”, the seller pays the buyer a certain amount for each CDD above “the strike”.

Pay-off Chart for the CDD Call Option

Cooling Degree Days (1855-2000) The chart shows frequency distribution of annual Cooling Degree Days at Melbourne using all data:

Cooling Degree Days (1971-2000) The chart shows frequency distribution of annual Cooling Degree Days at Melbourne using only recent data:

Returning to the Cane Grower Suppose that our cane grower has experienced an extended period of drought Suppose that if rain doesn't fall next month, a substantial financial loss will be suffered. How might our cane grower protect against exceptionally dry weather during the coming month?

One Approach One approach could be to purchase a Monthly Rainfall Decile 4 Put Option. Assume that our cane grower decides only to take this action when there is already a risk of a dry month. That is, when the current month's Southern Oscillation Index (SOI) is substantially negative. So, the example is applied only to the cases when the current month's Southern Oscillation Index (SOI) is in the lowest 5% of possible values, that is, below -16.4.

Specifying the Decile 4 Put Option Strike: Decile 4. Notional: $100 per Decile (< Decile 4). If, at expiry, the Decile is < Decile 4, the seller of the option pays the buyer $100 for each Decile < Decile 4.

Pricing Methodologies Historical simulation. Direct modeling of the underlying variable’s distribution. Indirect modeling of the underlying variable’s distribution (via a Monte Carlo technique).

Payoff Chart for Decile 4 Put Option

Outcomes for Decile 4 Put Option

Evaluating the Decile 4 Put Option 14.2% cases of Decile 1 yields $(.142)x(4-1)x100=$42.60 13.2% cases of Decile 2 yields $(.132)x(4-2)x100=$26.40 8.4% cases of Decile 3 yields $(.084)x(4-3)x100=$8.40 The other 25 cases (Decile 4 or above) yield nothing. …leading to a total of $77.40, which is the price of our put option.

Impact of Forecasts When very high temperatures are forecast, there may be a rise in electricity prices. The electricity retailer then needs to purchase electricity (albeit at a high price). This is because, if the forecast proves to be correct, prices may “spike” to extremely high (almost unaffordable) levels.

Impact of Forecast Accuracy If the forecast proves to be an “over-estimate”, however, prices will fall back. For this reason, it is important to take into account forecast verification data in determining the risk.

Using Forecast Verification Data Suppose we define a 38 deg C call option (assuming a temperature of at least 38 deg C has been forecast). Location: Melbourne. Strike: 38 deg C. Notional: $100 per deg C (above 38 deg C). If, at expiry (tomorrow), the maximum temperature is greater than 38 deg C, the seller of the option pays the buyer $100 for each 1 deg C above 38 deg C.

Pay-off Chart: 38 deg C Call Option

Determining the Price of the 38 deg C Call Option Between 1960 and 2000, there were 114 forecasts of at least 38 deg C. The historical distribution of the outcomes are examined.

Historical Distribution of Outcomes

Evaluating the 38 deg C Call Option (Part 1) 1 case of 44 deg C yields $(44-38)x1x100=$600 2 cases of 43 deg C yields $(43-38)x2x100=$1000 6 cases of 42 deg C yields $(42-38)x6x100=$2400 13 cases of 41 deg C yields $(41-38)x13x100=$3900 15 cases of 40 deg C yields $(40-38)x15x100=$3000 16 cases of 39 deg C yields $(39-38)x16x100=$1600 cont….

Evaluating the 38 deg C Call Option (Part 2) The other 61 cases, associated with a temperature of 38 deg C or below, yield nothing. So, the total is $12500. This represents an average contribution of $110 per case, which is the price of our option.

Ensemble Forecasting Another approach to obtaining a measure of forecast uncertainty, is to use ensemble weather forecasts The past decade has seen the implementation of these operational ensemble weather forecasts. Ensemble weather forecasts are derived by imposing a range of perturbations on the initial analysis. Uncertainty associated with the forecasts may be derived by analysing the probability distributions of the outcomes.

Some Important Issues Quality of weather and climate data. Changes in the characteristics of observation sites. Security of data collection processes. Privatisation of weather forecasting services. Value of data. Climate change.

Concluding Remarks The sophistication of weather-related risk management products is growing. In evaluating weather securities one needs to use historical weather data and forecast verification data, and also to take into account climate trends. Ensemble forecasting is a new approach to determining forecast uncertainty.