By Ronn Mullins, Insurance editorDerivatives For All Seasons

Ronn Mullins is the Insurance Editor for World-Generation and a Member of the Class of 2008.

Everybody talks about the weather, Mark Twain observed, but nobody does anything about it. True, nothing can alter the path or culmination of weather, but now with weather derivatives, the sharp sting can be lessened from the random effects of weather. These weather derivatives are especially applicable for companies supplying energy and those using it.

Simply, a derivative contract identifies a peculiar financial instrument that has no value in and of itself, but derives its value from assets or data that support it such as stocks, bonds, currencies, commodities, real estate, even weather.

Weather derivatives first appeared more than a decade ago when before the warm winter brought on by El Nino in 1997-1998, Aquila Energy executed a weather option for Consolidated Edison in New York that was embedded in a power contract.

Today, demand for weather derivatives continues to be strong worldwide, according to a survey published by the Weather Risk Management Association which was conducted by Price Waterhouse. The 2007 industry survey shows that the total number of contracts traded worldwide – both over-the-counter (OTC) and on the Chicago Mercantile Exchange (CME) -- was 730,087 for the period April 2006 through March 2007. Reflecting a shift from seasonal to monthly contracts on the CME, the notional value of contracts traded during 2007 dropped to $19.2 billion from 2006’s record of $45.2 billion. Still growth has been substantial. In 2005 the total value of contracts was $8.4 billion; in 2004, a mere $4.6 billion.

The basic trade inherent in weather-related risk management products is indexed on the Heating Degree Day (HDD), a widely used measure for the relative "coolness" of the weather in a given region during a specified period of time. HDDs are calculated using temperature data provided by the National Weather Service. For any given day, HDDs are calculated as the greater of (1) zero or (2) 65 degrees Fahrenheit less the midnight to midnight average of the high and low temperatures for the day.

Industries that use weather derivatives are primarily companies in energy-related businesses. Weather derivatives can hedge against too high temperatures for one industry and too low for another. For natural gas and propane/heating oil companies, a very important factor determining profit or loss for the company is the severity and duration of the winter. Warm winters can seriously affect the financial results of these companies, as the volume of natural gas and heating oil that is consumed during the winter season to a great extent determines their sales revenue and profits. Thus natural gas companies hedge against warm winters. The opposite is true for electric utilities. Cool summers reduce the demand for air conditioning which lessens the volume of electricity sold.

Weather can seriously delay the progress of a construction project. Weather derivatives written into a construction contract can hedge the risks and offset losses associated with adverse weather.

There are no great differences between the underwriting of a weather derivative and the more traditional weather insurance contract. Weather derivatives cover low-risk, high-probability events. Weather insurance, on the other hand, typically covers high-risk, low-probability events, as defined in a highly tailored, or customized policy.
But there are differences with adjusting a claim. Payouts from derivatives are based on objective data (temperature and precipitation records), not an assessed, measurable loss, which can bring disagreements and delay. With a payout from a derivative, the company with the contract can still profit. There is no moral hazard associated with a derivative, as no one can manipulate the weather.

Buying a weather derivative begins with a company or organization calculating an index that correlates the product it sells with how the weather affects it. “The company brings its risk to us and we tailor an index to address their risk,” explains Brian O’Hearne, managing director of Swiss Re’s environment and commodity market unit. “If we agree with the statistics after reviewing them, then we will offer a price for the derivative. If we don’t have an appetite for a particular risk, because we are not comfortable with the index, we will first work with the company to revaluate the data and ask it to resubmit.” Swiss Re is the largest writer of weather derivatives in the world.

He advised companies wanting to buy a weather derivative to “first and foremost know how the weather affects their business, so that they can come up with an index that suits their needs. They must think of the value of the program to them, balancing the price for the derivative against the benefit.”