“If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
-Poker proverb used by Warren Buffet in his 1987 Letter to Shareholders
As an old insurance bigwig (not Mr. B) once said to me, "These things are for writing, not buying"
From Institutional Investor:
The extreme weather of the past several weeks — from ice storms to blizzards to subzero temperatures — has undoubtedly had a harsh impact on the U.S. economy. From commodity producers to job creators, few have been thrilled about the weather. But the general disruption of weather patterns around the world has planted weather-related insurance in the minds of financiers, bringing the financial instrument of weather derivatives to the fore.
Weather derivatives were created in the late 1990s to help energy producers hedge against adverse atmospheric conditions. The first such contract was struck in July 1996, when the now defunct Aquila Energy structured a dual-commodity hedge for New York’s Consolidated Edison for its electricity needs that coming August.
That market has functioned sporadically ever since. Despite the fact that weather forecasting has nothing to do with economic prognostication, the financial crisis of 2008–’09 did lead to the exit of many of the banks and brokerages that had made markets in this area. Gradually, however, interest has returned, fueled by the hedging needs of industry and a new wave of investors looking to play weather risk.
According to the Washington–based Weather Risk Management Association (WRMA), the value of trades in the year ending March 2011, the last count, stood at $11.8 billion, far below the industry peak of $45 billion reached in 2005–’06. Unfortunately the vast disparity of weather-derivative-reporting sources has meant that WRMA has since decided to scrap its annual survey — the only independent statistical analysis of its kind — and there are no reliable sources of market volumes at present.
What is verifiable is that the business is undergoing a rebalancing in trading from exchange to over the counter. Exchange-traded contracts, trumpeted with much fanfare more than a decade ago, have seen declining volumes over the past three or four years and account for a small proportion of the overall market.
The Chicago Mercantile Exchange (CME), which lists more than 60 contracts including options and futures on rainfall, snowfall and temperature, is the world’s largest weather derivatives exchange. Weather derivative volumes on the CME slid by 16 percent in 2013 to 167,396 traded contracts. Despite the recent snow, the CME has yet to see any of its snow derivatives traded on exchange. In Europe derivatives exchange Eurex, based outside Frankfurt, saw no trading last year on its hurricane futures weather contracts, which are U.S. dollar–denominated and based on weather patterns in the Gulf of Mexico.
The decline of exchange-traded contracts is not, however, reflected in the OTC market, where business has been booming. According to Martin Malinow, president of reinsurer Endurance Global Weather in New York, the slump in exchange-traded products has been good for the OTC world.
“Exchange-traded products represent standardization in an increasingly bespoke world,” he says. “For a snow removal contractor in Milwaukee, if all that is available for hedging is a CME snow contract indexed to Chicago, he will potentially bear a large basis risk between his exposure and the hedging product. For the product to be relevant for a business with localized operations, the product needs to be indexed to a more specific location.”
Most of the OTC business is provided by reinsurers, weather specialists by trade. In December Swiss Re assumed a portion of the risk of the biggest-ever weather derivatives trade — a $500 million deal between the World Bank and Uruguay’s Ministry of Finance that became effective January 1 — to hedge rainfall risk associated with the Latin American country’s hydropower generators. It certainly caught the market’s attention, says Stuart Brown, head of origination, weather and energy for EMEA Asia-Pacific at Swiss Re Capital Markets in London.
“There was a short pause following the financial crisis, but hedgers have come back into the market very quickly,” he says. “We’ve seen more climate change awareness and more volatile weather, which means that these risk management products are entering the consciousness and becoming more mainstream”.
Though the market remains dominated by energy producers looking to hedge their specific production risks, things might also be changing from a demand perspective. Edgar Bautista, co-head of weather and commodities at Axis Capital in Islandia, New York, says that one of the biggest new sources of volume last year came from specialized hedge funds looking at weather risk for speculation as much as for hedging....MORE
