Come rain or come shine
With global warming no longer an ‘if’ but a ‘when’, interest has been growing in generating uncorrelated portfolio returns through weather-related risk instruments. John Bonaccolta reports.
Life on earth is getting hotter. Perhaps more important, not only are temperatures rising, but extreme weather events around the world seem to be occurring with increasing frequency.
Although debate still rages as to the underlying causes of such trends, weather affects most businesses and, according to the Weather Risk Management Association (WRMA), a trade group based in Washington DC, weather has an impact on about one-third of global GDP.
An example of volatile weather patterns is the 2005 Atlantic basin hurricane season, the most active in recorded history, during which more than 2,000 people were killed and more than $100bn-worth of damage was done. In 2006, by contrast, in a pattern not recorded since 2001, not one hurricane in this region made landfall.
It is precisely the volatility of such events that has put weather risk management on the radar screen of an increasing number of businesses, and in the past decade there has been a marked increase in the options available to manage these risks. But while many agree that the market for weather-related risk instruments is set to grow, it might take time for traditional asset managers such as pension funds to get comfortable with the tools.
The first insurance-linked security (ILS) instruments were catastrophe (cat) bonds, which date back to the mid-1990s following the disaster of Hurricane Andrew in 1992, the second most destructive hurricane in US history.
Cat bonds pay a healthy spread over LIBOR to bondholders but in the event of a natural catastrophe, such as a hurricane - a trigger event - the principal is forgiven. Should a trigger event occur, the sponsor receives the capital otherwise paid to the bondholder to fund its liability, and in the absence of a trigger, the bond pays high coupons to the bondholder for the assumption of such tail risk.
The frequency and severity of more recent events have racked up huge liabilities for the insurance and reinsurance sectors, causing many to revisit their actuarial risk models. From the perspective of an insurer or reinsurer, selling some of their liabilities to the capital markets mitigates their own balance sheet risk. And with an increasingly stringent regulatory environment, accessing capital through the financial markets permits insurers and reinsurers to avoid capital charges and penalties.
On the demand side of the equation, hedge funds and other speculators have been scouring the planet in recent years looking for new and innovative ways to boost returns in otherwise difficult markets. Taking on the tail risk of insurance and weather-related events has afforded these financial players the opportunity for alpha, which they have assumed willingly. The Dutch pension fund PGGM also invests in cat bonds through its portfolio of strategies approach.
A less extreme way of playing the weather might be through weather derivatives, which also seek to provide protection from adverse weather events, although not only in the extreme tail cases that cat bonds do. The first weather deal dates back to 1996, when Aquila energy structured a dual-commodity hedge for Consolidated Edison Co. And weather derivative contracts are now traded either over the counter or on the Chicago Mercantile Exchange (CME). The CME’s exchange-traded varieties cover 18 cities in the US, nine in Europe, six in Canada, and two in Japan.
Much of the volume revolves around temperature plays, where put and call contracts are offered in heating degree day (HDD) and cooling degree day (CDD) varieties for a given time period, whereby the strike is a given temperature and the payout is determined relative to the actual number of days above or below the strike in that time. CME products also include frost days, snowfall options, and other products.
Kendall Johnson, a managing director with Tradition Financial Services, a US-based global derivatives broker, says: “If you have any kind of energy position, you are implicitly either long or short weather.”
While this may be true, now 10 years on, the market has taken time to develop. Renaud Huck, associate director of sales and marketing for the CME, admits that weather derivatives are just beginning to solidify their place in the market. “The market is becoming a bit more educated and sensitive about these products - but as with any new product offering, awareness and comfort take time,” he says.
Many experts cite buoyant conditions on the speculative side as hedge funds and others have been lining up for alpha opportunities. But on the hedging side, companies have been slower to embrace such derivative products as a way of managing weather risks.
According to Johnson, part of the problem is that companies are still being let off the hook when weather adversely affects their financial performance, something that he says amazes him given the tools available in the marketplace.
With the right tools available, and with analysts and investors demanding more active management, will companies at some point be held to the task of managing their weather risks?
“It is a sensible question to ask given that people are getting increasingly comfortable with hedging other things, such as interest rates and foreign exchange,” says Richard Cooper, senior investment consultant for Mercer Investment Consulting based in the UK.
Although many have identified the most direct application of weather derivatives for risks to be associated with energy companies, a broad array of companies and sectors are exposed to significant weather risks, including leisure, tourism, retail, airlines, and most commodity products.
But there is hedging, and then there is opportunistic investing. On the hedging side, Cooper believes that managing weather risks will ultimately fall upon the corporates themselves, rather than the portfolio manager invested in their stocks.
Although he says that he can conceive of cases where more active strategies might want to look at such instruments on a speculative basis, he concedes that no clients that he speaks with are using such fringe instruments or strategies. However, some Dutch pension funds are known to be considering them.
Of course, much of the argument to include weather instruments in a portfolio is hinged on diversification arguments. Geophysical events offer a truly de-correlated asset class to complement others in a traditional portfolio.
In a 2004 paper published in the Journal of Alternative Investments, David Van Lennep, Teddy Oetomo, Maxwell Stevenson, and André de Vries found that including weather in a sample portfolio increased the expected return from 6.82% to 8.75%, and increased the Sharpe ratio from 0.52 to 0.78.1
Few dispute the fact that weather and catastrophe offer true diversification benefits, because they are uncorrelated with other asset classes. But are institutions ready to manage these instruments right now?
Geoff Considine, founder of Quantext, a consultancy that develops and deploys quantitative solutions for portfolio strategy, goes slightly further in questioning the role of catastrophe and weather in more traditional asset management circles.
“The challenge of weather derivatives and cat bonds is managing these instruments in the broader portfolio,” says Considine. “Both cat bonds and weather derivatives are relatively illiquid and hard, if not impossible, to consistently mark to market for that reason.”
He says that although many firms and their auditors are uncomfortable with the use of mark-to-model, some form of mark-to-model is necessary in effectively managing a portfolio of weather-related risks.
Considine also notes that liquidity risk can be substantial in these weather-related asset classes. “Are the portfolio managers really prepared to deal with these issues?” he asks. “The theory and practice of managing traditional security portfolios are far more mature than what can be found in the weather and cat bond markets, in my experience.”
Pablo Triana, professor at the Instituto de Empresa business school, Madrid, and a weather derivatives expert, remains positive on the prospects for broader use of these instruments, although he acknowledges that there are valuation challenges on the client side.
“Most current valuation methodologies for derivatives - such as Black-Scholes - assume an interchangeability of the derivative contract for the underlying physical asset,” says Triana. “With weather, there is no underlying asset, there’s just data.”
According to Triana, dealers have little problem pricing deals by using statistical analysis and simulation but clients experience difficulties in marking positions to market, challenges that don’t exist for, say, interest rate swaps or foreign exchange options.
But he is quick to point out that weather and catastrophe have been pushing the envelope of innovation from their beginnings. Triana notes that deals have been done on five continents, where even the World Food Programme, in a landmark 2005 transaction, moved to protect Ethiopian farmers from risks of drought through a weather contract.
Although engaging weather risk directly might take some time, some at present are accessing the space indirectly. Michael Millette, co-head of North American structured finance at Goldman Sachs, says that most pension and other traditional asset managers have been accessing the catastrophe space through speciality funds.
“There are currently 14 or so of these funds with about $7.5bn under management, which is up from zero in 1998,” says Millette.
From 1998 to the first half of 2005, Millette explains, the cat bond market grew relatively slowly, seeing annual issuance of $1-2bn , with “several dozen core investors”, out of a total of about 100 institutions, buying the lion’s share of the debt. This all changed with Hurricane Katrina in the second half of 2005, when more than 100 additional institutions entered the cat bond market, making the demand side much more complex, according to Millette.
Millette adds that now it is often the case that there is very limited overlap of institutions among different tranches: where hedge funds often make up much of the demand for B-rated tranches, BB-rated tranches see more catastrophe funds, and BBB-rated ones life insurers and banks, for example.
One noteworthy speciality fund manager is Nephila Capital, a Bermuda-based hedge fund manager that specialises in the reinsurance industry, with multiple investment products dedicated to investing in such instruments as insurance-linked securities, catastrophe bonds, insurance swaps, and weather derivatives.
Barney Schauble, principal at Nephila Capital, says that about 90% of the firm’s business is related to catastrophe risk, with roughly 10% devoted to weather derivatives and related products.
He notes, however, that investor interest for weather products has grown every year, and continues to do so. Nephila has more than $2bn in total assets under management.
“Our investor base includes pension funds from both North America and Europe in both catastrophe and weather funds,” says Schauble.
There are currently not many ways for pensions and other players to access the market. Multi-strategy hedge funds such as Citadel and DE Shaw offer one way, speciality funds such as Nephila and Coriolis Capital another, and indices such as UBS’s global warming index, launched in April 2007, a third.
In cases where the complexity of creating and valuing cat and weather instruments internally remains a stumbling block for institutional investors, Nephila is content playing expert, matching institutional capital seeking returns with insurers, reinsurers, and corporates that want to offload risk. The firm has external relationships with meteorologists directly, and even has an in-house transformer, which is essentially a reinsurance company that facilitates the conversion of reinsurance contracts into securities.
Although many market observers contend that weather products are inherently complicated, David Friedberg, co-founder and CEO of Weatherbill.com, is seeking to bring weather to the masses. Weatherbill is an online solution that provides tailor-made solutions to businesses of all sizes. Whereas the trading desks of Goldman Sachs and other houses pore over calculations and call in armies of lawyers to structure deals, Friedberg and his team offer quotes over the web, and immediate pricing.
“It’s not that complicated - it’s really just math,” says Friedberg, a former founding member of Google’s corporate development team. Friedberg launched Weatherbill in 2006 with his partner Siraj Khaliq, another Google veteran. Nephila provides all of the risk capacity to Weatherbill.
“We’re automating pricing, structuring, and settlement,” says Friedberg. “Companies are oftentimes exposed to very precise, specific risks related to weather - we’re really at the very beginning of this market. Twenty years ago, the mortgage market took a complicated, customised product and securitised it. We think the weather market will evolve in much the same way.”
Friedberg admits that the level of his clients’ sophistication is quite varied at the moment, with some companies very aware of their weather exposure and others not at all.
But if Weatherbill’s service takes off, it could certainly provide another level of awareness to a market that is moving beyond its nascent stage. The liquidity that everyone is looking for might just follow.
(1) “Weather derivatives: an attractive additional asset class,” by David Van Lennep, Teddy Oetomo, Maxwell Stevenson, and André de Vries. Journal of Alternative Investments, Fall 2004