Weather vane points to two financial instruments: while weighing the benefits of both routes is important, the derivative vs. insurance question is often resolved as a function of a company’s corporate culture and past experience – Industry Risk Report
For of those of us who live in the Northeast, comes as hardly a surprise it that the weather is one of the biggest risks that energy companies face. Record low temperatures seem to push the daily cost of energy higher and higher and can affect the bottom line for energy companies. But it’s more than just temperature that affects an energy company’s weather risk.
As energy companies seek to mitigate the effect of weather on their business, the weather risk market has picked up steam. From 1997, when the first weather risk management deal was arranged, until today, the market has experienced significant growth and interest. Today it’s big business.
According to surveys performed by PricewaterhouseCoopers and the Weather Risk Management Association, the notional value of weather contracts exchanged in the marketplace up until April 2003 has approached $16 billion. Undeniably, the energy industry was a catalyst of the initial market growth. After all, even slight weather fluctuations can severely affect demands for power and fuel, and thus, the financial balance of an energy company. Now, however, weather risk management is actively considered by retail, agricultural and construction companies.
Weather insurance and derivatives are the risk tools that may be available. Insurance is, of course, a familiar product. While weather derivatives area fairly new development, derivatives have been used in the agriculture industry for more than a century. They are also an integral part of the international currency and interest rate markets.
Although derivatives and insurance are often designed to accomplish the same goal, there are some fundamental differences.
For one, weather derivatives are index-based, requiring that a temperature, precipitation level, of other weather trigger be breached in order for payment to occur. A company that purchases a derivative contract will therefore receive payment if the weather event described in the transaction is shown to have occurred, regardless of whether the company actually incurs a loss. Weather insurance, on the other hand, requires both an index measure as well as proof of ah actual economic loss on the part of the purchaser.
But when looking to manage weather risk, which one–derivative or insurance policy–is the right one? Why? And when?
Derivatives may give a company more flexibility than insurance, allowing them to cancel (or sell back) a derivative contract in midterm based on weather patterns and similar factors. Insurance policies are generally held for the full term and aren’t treated as tradable instruments.
On the other hand, current accounting methodologies that determine how derivatives and insurance must be reported on a company’s books are somewhat more favorable to insurance.
With respect to documentation, the legal framework for derivative transactions is based on language developed by the International Swaps and Derivatives Association. ISDA recently published standard confirmation language for weather derivative swaps and options. However, even with the published standards, putting ISDA documentation in place between two companies can be a time-consuming process. Buying a weather insurance policy does not require the creation or modification of ISDA documentation, but the issuance of an insurance policy. Because an individual policy tends to be more limited in scope than derivative documentation, the process can be simpler. On the other hand, ISDA documentation may allow for multiple transactions to be considered collectively (netted) in the event of a bankruptcy; insurance policies are treated as individual transactions.
There are also tax issues to consider. Premiums on a derivative must be classified as an investment. They are not immediately deductible. Insurance premiums, on the other hand, are immediately deductible and the recovery on a derivative is treated as capital whereas recovery on insurance is treated as ordinary. However, companies reviewing any accounting or tax considerations are advised, as always, to consult their own tax accounting professional. While weighing the benefits of both routes is important, the derivative vs. insurance question is often resolved as a function of a company’s corporate culture and past experience. Those companies experienced in trading have a much easier time transacting derivatives than those that are not. Without a past history of trading, many companies find a greater comfort level with an insurance policy.
Fortunately, a growing number of industries understand the benefits of today’s weather risk management products and are finding both derivatives and insurance useful tools for controlling what was once deemed the uncontrollable whims of weather. For weather exposure, the decision is no longer whether to hedge but how to create the most effective weather risk management solution.
Michael Corbally is executive rice president of XL Weather & Energy Inc., formerly Element Re Capital Products. His opinions expressed in this article do not necessarily reflect those of the XL Capital group of companies.
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