Weather Risk Management - Currents and Future Developments

1. Weather Risk Management- Currents and Future Developments Prepared for Meteorological and Hydrologic Cooperation January 2002 Tokio Marine Management, Inc Integrated Solutions Group

2. Brief Introduction of Tokio Marine group State of weather risk financing market Weather risk financing products development- data needs and modeling Future Challenges Agenda

3. Tokio Marine and Fire Insurance Co., Ltd. Japan’s largest P&C insurer with the assets over $75 Billion and the premium income of $12 Billion Domestically diversifying its business base into Life insurance Asset management Securities business Leading risk financier in the area of Japanese corporate risk management Deregulation of domestic insurance markets in late 90’s encouraged to diversify its activities in international markets. Introduction

4. Early participant in the area of “alternative risk transfer (ART)” market where insurance and financial expertise converge Examples include; Weather Insurance and Weather Derivatives Earthquake and Typhoon risk financing Catastrophe Bond and Catastrophe Risk Swap Transactions Weather risk financing markets gives opportunities both in Japanese and international markets Virtually “untapped” Capability for managing and taking event risk Opportunities at meteorological services industry Introduction – con’t

5. Started 1997 in the U.S., initially along with the deregulation of utility market Weather derivative/insurance contracts were introduced then with the limited number of early market players, including Enron Spread more internationally after 2000, including North America, Japan and Europe; limited example in non-Japan Asia and other emerging regions Increasing interests in both local national and multinational governmental organizations to exchange opportunities with market players e.g. Draught risk financing in Morocco by World Bank www.risk-conferences.com/weather2002 State of weather risk financing market

6. Aquila Axia Energy Axa Bank of Tokyo-Mitsubishi BNP Paribas Commercial Risk Dynegy El Paso Merchant Energy Element Re Capital Products Enron Global Markets Hess Industrial Bank of Japan Mirant Mitsui Sumitomo Marine Many are chasing weather risk markets… • Mitsui Sumitomo Bank • Société Générale • Swiss Re • Tempest Re • Tokio Marine • TFS Energy • United Weather • Yasuda Fire • Zurich Re

7. Weather derivative market is said … already reached $10 Billion (of notional value) in U.S. market will grow as much as $3-5 Billion in Japan only soon Real transactions do not seem to pick up as fast as many would expect existence of trading (i.e. catch ball) markets real users start slowly but firmly still “pricey” and “tailor-made (i.e. time-consuming)” product to purchase beware, it’s a “derivative” contract who will be ultimate risk takers anyway? Is this market at least as reliable as traditional insurance and financial markets? Some figures for interests…

8. Utilities eye 'weather derivative' dealOSAKA -- Kansai Electric Power Co. and Osaka Gas Co. have said they planned to arrange a "weather derivative" contract under which weather risks on profits are to be leveled between the firms. Under the planned contract, announced Tuesday, when Kepco generates greater profits than expected in a scorching summer due to increased power consumption for air conditioners, it will pass on part of the profits to Osaka Gas, which usually sees lower gas demand when temperatures are high. The two companies will do the opposite in cool summers that undermine the power firm's profits while boosting those at the gas company. Tokyo Electric Power Co. and Tokyo Gas Co. signed a similar contract for this summer. Kepco and Osaka Gas said they will examine the feasibility of the derivative contract at a new company they will set up in January. The new firm, in which the companies will invest 5 million yen each, will also examine the feasibility of various other joint projects, they said. Those projects will include recycling industrial waste and environmental protection, they added. The Japan Times: Nov. 22, 2001 A Japanese example

9. Many efforts to attract untapped weather risk financing Source: cyber-JN.com

10. Value Chain of Weather Risk Financing Products Development Risk assessment and data mining Structurereliable risk parameters to trade Transacting among risk financiers InsuranceMarket Financial Market Risk Financing Markets Trading Market Final Market

11. Temperature has been the seed of weather risk products Quality of Climate data and modeling risk parameters is critical Data Raw/Cleaned/Enhanced(or, Reconstructed) data Resolution – 0.1 degree level is critical in pricing Providers Modeling risk parameters First generation: Index model (e.g. HDD, CDD) Second generation: Daily model Expanding the areas of weather data and modeling expertise will be also in increasing demand Data Precipitation, Wind, Snowfall, Draught, etc Regional resolution Detailed resolution International comparability Quest for weather risk parameters

12. Cleaned Data Completing raw data by filling missing values and/or correcting errors. Reconstruction (or, Enhanced) Data Goal; to use historical data as much as possible in a consistent manner Reconstructing all cleaned raw data by replacing any original values which are affected due changes in Instruments Locations Environmental factors Issues Who does the clean-ups and reconstruction? Is there a consistent methodology and application to manage and maintain database? International standards? Non-temperature data? Use of synoptic data? Temperature data

13. Climetrix model (Risk Management Solutions) The new daily model offers an alternative to the index modeling capabilities also available within the Climetrix system. While index models rely on an aggregate-level analysis of historical index values, the new RMS daily simulation model analyzes weather risk by simulating the day-by-day progression of temperatures over thousands of years of simulated weather. The model uses extensive records of historical daily temperature data for individual weather stations as the baseline for this analysis.Source:www.climetrix.com Cao and Wei ModelThe key advantages of our model include the use of weather forecasts as inputs and the ability to handle contracts of any maturity, for any reason… the so-called historical simulation method can lead to significant pricing errors due to its erroneous implicit assumptions.Source: http://qed.econ.queensu.ca/pub/faculty/cao/weather.pdf Daily model

14. More complete (complex?) models? • Simplicity is the key to promote trades in weather risks, even taking risks of oversimplifying • Financial derivatives • B-S model • Complex econometric model has never been used in trading financial contracts in practice • Weather derivatives • Daily models seem to be preferred • Global climate models – too complex to use? • Complex climate modeling may be useful if they better explains • structural shift(e.g. de-trending global warming effect) • regional interdependence(e.g. correlation factors between Northeast and Midwest) • factorial interdependence(e.g. correlation factors between temperature and rainfall)

15. Unlimited tailoring needs • There are more challenges in dealing with different complexity tocustomize individual risk financing programs • Up to 20% to 30% of a nation’s GDP could be weather related • Major instances of weather related industry include; • Energy • Agriculture • Entertainment • Transportation (incl. Aviation) • Travel • Construction • Retailing • Beverage • Electronics (especially seasonal) • Every industry and corporation has different risk financing need by using appropriate data and risk modeling

16. To risk financing market players, forecasts are useful to gain estimates of confidence interval of risk parameters Useful forecasts should focus predicting variability with a transparent analysis, as well as mean estimation Market players generally prefer forecasts with the following characteristics Quantitative show robustness of the predictability dependable database with a clear set of cautions to use Multi-dimensional presenting the variability of the analysis on influential factors Representative providing the evaluation regarding general acceptance and criticism in academic community Forecasts – how important?

17. Current examples of dealing with uncertainty A financial contract document of hurricane risk securitization writes; Recent research suggests that the El Nino phase of the El Nino Southern Oscillation Cycle (ENSO) may be associated with reduced tropical cyclone formation activity in the Atlantic Ocean, whereas the “La Nina” phase may be associated with increased tropical cyclone activity. Currently, the occurrence and magnitude of such climate factors cannot be predicted reliably. In any given year, there is large uncertainty in the frequency and severity of Hurricane loss. … model does not explicitly include any effect that the ENSO phase, Western African Sahel rainfall, or other climatic factors may have on the frequency or severity of Hurricanes making landfall in the United States. The Chartered Insurance Institute (UK) writes; It is not possible to estimate the cost of climate change accurately. Experience in the insurance industry shows that small changes in the severity of events can generate enormous increases in damage. … Consider the issue of insurability in high-hazard areas, and particularly how to prevent the problem from growing. Any numbers to describe those uncertainties? Anyone?

18. Future Challenges