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  1. 1. Alternative Risk Transfer and the Weather Market Shiva Pillai Rajesh Bangera Harish Narula
  2. 2. Contents of Presentation <ul><li>Alternative Risk Transfer (ART). </li></ul><ul><li>- definition </li></ul><ul><li>The Weather Market. </li></ul><ul><li>- current status </li></ul><ul><li>Channels for Weather Risk Transfer. </li></ul><ul><li>- securitisation </li></ul><ul><li>- catastrophe bonds </li></ul><ul><li>- weather derivatives </li></ul>
  3. 3. Background <ul><li>Weather risk is one of the biggest uncertainties facing business. </li></ul><ul><li>We get droughts, floods, fire, cyclones (hurricanes), snow & ice. </li></ul><ul><li>Nevertheless, economic adversity is not restricted to disaster conditions. </li></ul><ul><li>A mild winter ruins a skiing season, dry weather reduces crop yields, & rain shuts-down entertainment & construction. </li></ul>
  4. 4. Weather & Climate Forecasts <ul><li>Daily weather forecasts may be used to manage short-term risk (e.g. pouring concrete). </li></ul><ul><li>Seasonal climate forecasts may be used to manage risk associated with long-term activities (e.g. sowing crops). </li></ul><ul><li>Forecasts are based on a combination of solutions to the equations of physics, and some statistical techniques. </li></ul><ul><li>With the focus upon managing risk, the forecasts are increasingly being couched in probabilistic terms. </li></ul>
  5. 5. Industry Risk <ul><li>&quot;Shares in Harvey Norman fell almost 4 per cent yesterday as a cool summer and a warm start to winter cut into sales growth at the furniture and electrical retailer's outlets… Investors were expecting better and marked the shares down 3.8 per cent to a low of $3.55… </li></ul><ul><li>Sales at Harvey Norman were hit on two fronts. Firstly, air conditioning sales were weak because the cool summer, and a warmer than usual start to winter had dampened demand for heating appliances”. </li></ul><ul><li>Source: The Australian of 18 April, 2002 </li></ul>
  6. 6. Agricultural Risk <ul><li>“ The Australian sugar industry is facing its fifth difficult year in a row with a drought dashing hopes of an improved crop in Queensland, where 95% of Australia's sugar is grown... </li></ul><ul><li>Whilst dry weather during the May-December harvest period is ideal for cane, wet weather during this time causes the mature cane to produce more shoots and leaves, reducing its overall sugar content”. </li></ul><ul><li>Source: Australian Financial Review of 8 May, 2002 </li></ul>
  7. 7. Should Companies Worry? <ul><li>In the good years, companies make big profits. </li></ul><ul><li>In the bad years, companies make losses. </li></ul><ul><li>- Doesn’t it all balance out? </li></ul><ul><li>- No. it doesn’t. </li></ul><ul><li>Companies whose earnings fluctuate wildly receive unsympathetic hearings from banks and potential investors. </li></ul>
  8. 8. What is ART? <ul><li>ART (Alternative Risk Transfer) is a generic phrase used to denote various non-traditional forms of re/insurance and techniques where risk is transferred to the capital markets. </li></ul><ul><li>Source: </li></ul>
  9. 9. The Weather Market - Growth. <ul><li>3,937 contracts transacted in last 12 months (up 43% compared to previous year). </li></ul><ul><li>Notional value of over $4.3 billion dollars (up 72%). </li></ul><ul><li>Market dominated by US (2,712 contracts), but growth in the past year is especially so in Europe and Asia. </li></ul><ul><li>Australian market accounts for 15 contracts worth over $25 million (6 contracts worth over $2 million, previously). </li></ul><ul><li>Source: Weather Risk Management Association Annual Survey (2002) </li></ul>
  10. 10. Weather-linked Securities <ul><li>Weather-linked securities have prices which are linked to the historical weather in a region. </li></ul><ul><li>They provide returns related to weather observed in the region subsequent to their purchase. </li></ul><ul><li>They therefore may be used to help firms hedge against weather related risk. </li></ul><ul><li>They also may be used to help speculators monetise their view of likely weather patterns. </li></ul>
  11. 11. Securitisation <ul><li>The reinsurance industry experienced several catastrophic events during the late 1980s & early 1990s. </li></ul><ul><li>The ensuing industry restructuring saw the creation of new risk-management tools. </li></ul><ul><li>These tools included securitisation of insurance risks (including weather-related risks). </li></ul><ul><li>Weather securitisation may be defined as the conversion of the abstract concept of weather risk into packages of securities. </li></ul><ul><li>These may be sold as income-yielding structured products. </li></ul>
  12. 12. Catastrophe Bonds <ul><li>A catastrophe (cat) bond is an exchange of principal for periodic coupon payments wherein the payment of the coupon and/or the return of the principal of the bond is linked to the occurrence of a specified catastrophic event. </li></ul><ul><li>The coupon is given to the investor upfront, who posts the notional amount of the bond in an account. </li></ul><ul><li>If there is an event, investors may lose a portion of (or their entire) principal. </li></ul><ul><li>If there is no event, investors preserve their principal and earn the coupon. </li></ul><ul><li>Source: Canter & Cole at </li></ul>
  13. 13. Catastrophe Swaps <ul><li>A catastrophe (cat) swap is an alternative structure, but returns are still linked to the occurrence of an event. </li></ul><ul><li>However, with swaps, there is no exchange of principal. </li></ul><ul><li>The coupon is still given to the investor upfront, but the structure enables investors to invest the notional amount of the bond in a manner of his own choosing. </li></ul><ul><li>Source: Canter & Cole at </li></ul>
  14. 14. Weather Derivatives <ul><li>Weather derivatives are similar to conventional financial derivatives. </li></ul><ul><li>The basic difference lies in the underlying variables that determine the pay-offs. </li></ul><ul><li>These underlying variables include temperature, precipitation, wind, and heating (& cooling) degree days. </li></ul>
  15. 15. A Weather-linked Option <ul><li>An example of a weather linked option is the Cooling Degree Day (CDD) Call Option. </li></ul><ul><li>Total CDDs is defined as the accumulated number of degrees the daily mean temperature is above a base figure. </li></ul><ul><li>This is a measure of the requirement for cooling. </li></ul><ul><li>If accumulated CDDs exceed “the strike”, the seller pays the buyer a certain amount for each CDD above “the strike”. </li></ul>
  16. 16. Pay-off Chart for the CDD Call Option
  17. 17. Pricing Methodologies <ul><li>Historical simulation. </li></ul><ul><li>Direct modeling of the underlying variable’s distribution. </li></ul><ul><li>Indirect modeling of the underlying variable’s distribution (via a Monte Carlo technique). </li></ul>
  18. 18. Impact of Forecasts <ul><li>When very high temperatures are forecast, there may be a rise in electricity prices. </li></ul><ul><li>The electricity retailer then needs to purchase electricity (albeit at a high price). </li></ul><ul><li>This is because, if the forecast proves to be correct, prices may “spike” to extremely high (almost unaffordable) levels. </li></ul>
  19. 19. Impact of Forecast Accuracy <ul><li>If the forecast proves to be an “over-estimate”, however, prices will fall back. </li></ul><ul><li>For this reason, it is important to take into account forecast verification data in determining the risk. </li></ul>
  20. 20. Using Forecast Verification Data <ul><li>Suppose we define a 38 deg C call option (assuming a temperature of at least 38 deg C has been forecast). </li></ul><ul><li>Location: Melbourne. </li></ul><ul><li>Strike: 38 deg C. </li></ul><ul><li>Notional: $100 per deg C (above 38 deg C). </li></ul><ul><li>If, at expiry (tomorrow), the maximum temperature is greater than 38 deg C, the seller of the option pays the buyer $100 for each 1 deg C above 38 deg C. </li></ul>
  21. 21. Pay-off Chart: 38 deg C Call Option
  22. 22. Determining the Price of the 38 deg C Call Option <ul><li>Between 1960 and 2000, there were 114 forecasts of at least 38 deg C. </li></ul><ul><li>The historical distribution of the outcomes are examined. </li></ul>
  23. 23. Historical Distribution of Outcomes
  24. 24. Evaluating the 38 deg C Call Option (Part 1) <ul><li>1 case of 44 deg C yields $(44-38)x1x100=$600 </li></ul><ul><li>2 cases of 43 deg C yields $(43-38)x2x100=$1000 </li></ul><ul><li>6 cases of 42 deg C yields $(42-38)x6x100=$2400 </li></ul><ul><li>13 cases of 41 deg C yields $(41-38)x13x100=$3900 </li></ul><ul><li>15 cases of 40 deg C yields $(40-38)x15x100=$3000 </li></ul><ul><li>16 cases of 39 deg C yields $(39-38)x16x100=$1600 </li></ul><ul><li>cont…. </li></ul>
  25. 25. Evaluating the 38 deg C Call Option (Part 2) <ul><li>The other 61 cases, associated with a temperature of 38 deg C or below, yield nothing. </li></ul><ul><li>So, the total is $12500. </li></ul><ul><li>This represents an average contribution of $110 per case, which is the price of our option. </li></ul>
  26. 26. Ensemble Forecasting <ul><li>Another approach to obtaining a measure of forecast uncertainty, is to use ensemble weather forecasts </li></ul><ul><li>The past decade has seen the implementation of these operational ensemble weather forecasts. </li></ul><ul><li>Ensemble weather forecasts are derived by imposing a range of perturbations on the initial analysis. </li></ul><ul><li>Uncertainty associated with the forecasts may be derived by analysing the probability distributions of the outcomes. </li></ul>
  27. 27. Some Important Issues <ul><li>Quality of weather and climate data. </li></ul><ul><li>Changes in the characteristics of observation sites. </li></ul><ul><li>Security of data collection processes. </li></ul><ul><li>Privatisation of weather forecasting services. </li></ul><ul><li>Value of data. </li></ul><ul><li>Climate change. </li></ul>
  28. 28. Concluding Remarks <ul><li>The sophistication of weather-related risk management products is growing. </li></ul><ul><li>In evaluating weather securities one needs to use historical weather data and forecast verification data, and also to take into account climate trends. </li></ul><ul><li>Ensemble forecasting is a new approach to determining forecast uncertainty. </li></ul>