Weather derivatives’ regulation: open issues and new opportunities for risk coverage products

1. Weather derivatives’ regulation: open issues and new opportunities for risk coverage products Paolo Rainelli AIDA PresidentialCouncil Meeting – May 4, 2012, Istanbul ClimateChangeWorking Party

2. Weather derivatives • A derivativeis a financial product, the value of which derives from an underlying index, rate, commodity or other variable element. • The special feature of weather derivatives is that the underlying element is represented by weather-related indexes such as temperature, rainfall, snowfall, wind, etc. • Two variants: customizedweather derivatives vs. standardized weather derivatives (tradable). • Origin: Aquila Energy structured a dual-commodity hedge for Consolidated Edison (USA ,1996) • However the weather component was embedded in the very first derivative transactions: weather forecasts and renting of olive mills/presses by Thales of Miletus (Asia Minor 600 B.C.).

3. “The insurance industry was not then receptive to requests to provide non-catastrophic protection. Accordingly, the energy market was left to fend for itself. Energy companies, realizing that the market was changing, took control of their weather risk and created a new business around it” LyndaClemmons(former head ofEnronEnvironmental Desk, 2002)

4. Some figures… • The weather derivatives market expanded from being a very small U.S. energy product (back in 1997) to quickly become a USD 11.8 billion industry by 2011 (WRMA). • A growing market (thatsurviveditspioneers, namelyEnron). • According to data collected by WRMA, during the 2010-2011 period: • the market for customized weather derivatives grew by nearly 30%; • the total notional value for OTC contracts rose to USD 2.4 billion; • the overall market grew to USD 11.8 billion (20% increase).

5. Who needs weather derivatives? • Number of potential “end-users”: • Energy (and other utilities); • Agriculture; • Travel; • Manufacturer of weather-driven seasonal products; and • Insurance (covering third parties’ weather-related risks). • Traditional use of derivatives in the insurance business (e.g., hedging currency risk, stock market fluctuations, interest rates) but weather derivatives may also allow insurers “to cope with climate changes”(Marcel Fontaine - AIDA World Congress 2010). • Together with CAT bond, they represent a form of alternative risk transfer (ART) when reinsurance capacity is limited or too expensive.

6. Benefits of weather derivatives • Assuring smooth revenues and compensating for the loss of demand: for instance a utilities company might want to hedge the decreased revenues due to a warm winter. • Covering excess costs: for instance, industrial consumers of energy might want to hedge the cost of purchased electricity associated with peak load demand. • Reimbursing lost opportunity costs: firms operating in weather dependant sectors might want to hedge the risks of stock-outs. • Stimulating sales: firms (particularly in the travel sector) might use weather derivatives to back up their “money back guarantee” clauses within their customer satisfaction policies . • Diversifying investment portfolios: financial investors – who are not directly exposed to weather related risks – might want to take advantage of the low correlation between returns associated with weather and returns from other asset classes.

7. Typesofweatherderivatives • Floorsgrant downside protection when the underlying weather variable falls below the established threshold (whereas the upside remains unconstrained). • Cap derivatives provide compensation if the underlying weather variable goes above a certain level. • Collars and swaps usually involve parties having opposite interests exchanging their respective risks (one party buys a floor and sells a cap). • Futures (most common type of publicly traded weather derivative at the Chicago Mercantile Exchange) incorporate the commitment to deliver or accept a commodity (e.g., temperature or other weather index) at a certain time and at a certain price. Variations above or below that price trigger a cash settlement between the buyer and seller.

8. Weatherderivativesvs. InsuranceContracts • Weather derivative are (mostly) intended as risk-shifting instruments • Soundsfamiliar? YES • Debatearoundrelationshipbetweenweatherderivatives and insurancecontracts • Derivativesrapidlyturnedfrom a resource (alternative risk management) into a threat (potential and/or actualcompetitionwithtraditionalinsurancepolicies). • The NAIC battle: in 2003 the National Association of Insurance Commissioners (NAIC) released a draft white paper arguing that weather derivatives were “disguised” insurance contracts and recommending a legislative intervention on authorization and monitoring of their issuance. • Unfaircompetitionbetweenheavilyregulatedinsurancecompanies and virtuallyunregulatedplayers.

9. Weatherderivativesvs. InsuranceContracts (2) • If weather derivatives were found to be disguised insurance policies, only licensed insurance brokers would have been authorized to sell such products. • Unsuccessful outcome of the 2003 NAIC battle: paper was never released, immediate reactions by WRMA and International Swaps and Derivatives Association (ISDA). • Despite the similarities between weather derivatives and weather-risk insurances, functional equivalence must be distinguished from legal equivalence. • Presumably the discussions on the different “legal nature” of weather derivatives – at least in the USA – have come to an end.

10. Weatherderivativesvs. InsuranceContracts (3) The insured party: • must have an insurable risk with respect to a fortuitous event that is capable of a financial estimate; • must “transfer” its “risk of loss” to the insurance company; • pays a “premium” to the company for assuming the risk; • in order to collect the indemnity, must provide evidence of an actual lossand the payment is limited to an amount equal to the lesser of the insured’s actual loss or the maximum amount of loss covered. The insurance company: • assumes the risk as part of a larger program for managing loss by holding a large pool of contracts covering similar risks (risk distribution or risk spreading). None of the statementsaboveapplytoweatherderivatives

11. “The subject matter of a weather option is the specified weather component and it is a conceptual impossibility for anyone to have an economic interest in the elements” WRMA’s answer to NAIC draft white paper , 2004

12. What’s going on? • Unenforceability issues in purely speculative environments (gambling exceptio); • “Commodification” of weather indexes. Consolidation of weather derivatives’ treatment as “commodity derivatives” (trying to address overlap with insurance products and gambling issues); • Similar market structures. Primary market : secondary market = insurance : reinsurance • Existence of regulatory constraints. In certain jurisdictions prohibition for insurers or reinsurers to “sell” or issue weather derivatives (as they are not insurances); • Disclosure/pre-contractual information • Pricing models (e.g., market based, actuarial) impact of climate change • Different tax (over premiums/price) and accounting treatments

13. What’s aheadforinsurancecompanies? • TRADING. Insurance companies continue using weather derivatives as alternative risk transfer tools/reinsurance products (a well-established and mature market); • ISSUANCE. Insurance companies start (or strengthen) the issuance/sale of customized weather derivatives (requires regulatory changes in certain jurisdictions and/or intra-group separation); • CONVERGENCE: a so-called “weather derivative component” incorporated into traditional insurance products (affecting the economics or the dynamics of the contract). Probably new opportunities for non-catastrophic risk coverage products