weather risk management

Weather Risk Management

UNIVERSITY of HOUSTONFebruary 24, 2005

Weather risk affects a broad cross-section of global businesses in a variety of ways.

Read how some of these companies describe their exposure…

“Both 1997 and 1998 fiscal results were impacted by extremely harsh winter patterns that flooded over 41,000 acres of the Company’s Corcoran farming districts causing a decrease of $1,000 per acre or $41 million in gross revenues. Additionally, cold and wet spring weather delayed cotton planting by up to six-weeks which resulted in some of the worst farming conditions management has ever seen.”

JG BOSWELL – LARGEST US COTTON GROWER

“Both 1997 and 1998 fiscal results were impacted by extremely harsh winter patterns that flooded over 41,000 acres of the Company’s Corcoran farming districts causing a decrease of $1,000 per acre or $41 million in gross revenues. Additionally, cold and wet spring weather delayed cotton planting by up to six-weeks which resulted in some of the worst farming conditions management has ever seen.”

“Weather was an important factor affecting cement demand, with unusually high precipitation levels in August and September, when compared to the same months of 2002.”

CEMEX - #3 CEMENT MAKER WORLDWIDE

“Weather was an important factor affecting cement demand, with unusually high precipitation levels in August and September, when compared to the same months of 2002.”

REDDY ICE – LARGEST US ICE MANUFACTURER

“Cool or rainy weather can decrease sales, while extremely hot weather may increase our expenses, each resulting in a negative impact on our operating results and cash flow.”

“Cool or rainy weather can decrease sales, while extremely hot weather may increase our expenses, each resulting in a negative impact on our operating results and cash flow.”

“Major variation in runoff is Hydro-Québec’s greatest risk, since 93% or our electricity is generated from hydropower …Significant temperature variances have an appreciable impact on seasonal demand.”

HYDRO QUEBEC – HUGE NA GENERATOR

“Major variation in runoff is Hydro-Québec’s greatest risk, since 93% or our electricity is generated from hydropower …Significant temperature variances have an appreciable impact on seasonal demand.”

1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas

Company5.Case Study II: Dry Creek Hydro

Electric6.How do you manage a book of

weather risk?7.Your career8.Q&A

Weather risk management

Financial weather risk is the occurrence of an observable weather event or variability in a measurable weather index that causes losses either to property or profits for an individual, government or corporation.

Weather risk management products – packaged as either (re)insurance or derivatives – are settled off of the same index that has been determined to cause losses and reduces weather risk through mitigating payouts.

Types of weather risk

NON-CATASTROPHIC CATASTROPHIC

VARIABLESTEMPERATURE PRECIPITATION

HURRICANES TORNADOS

IMPACT INCOME STATEMENT BALANCE SHEET

FREQUENCY REGULAR RARE

TIMING CUMULATIVE IMMEDIATE

SOURCE OPERATING EXOGENOUS

TRADITIONAL MANAGEMENT

RETAIN INSURE

MARKET VIEWBUSINESS RISK –

IMPACTS EARNINGS QUALITY

UNIQUE EVENTS – NO EARNINGS PENALTY

Manageable weather risks

Temperature

Precipitation

Snowfall

Wind Speed

Streamflow

Sunshine hours

Hail

Soil Moisture

Humidity

Hurricane

Tornados

A weather index is generally constructed as a function of frequency of occurrence and magnitude of event.

RisksTemperature (F/C): Minimum, Maximum or Average

Precipitation: Rainfall and Snowfall

Combinations: Dual Trigger Products

Measurement and IndicesCritical Day: Specific daily criteria – above or below (ie “Peak Days”)

Aggregate: Accumulation of events over defined period (ie Seasonal Precipitation)

Average: Mean outcome of events over defined period (ie Avg Temperature)

Current weather market index complex

Key is acceptable historical data and ongoing measurement

PRICEPRICE VOLUMEVOLUME REVENUEREVENUExx ==

PRICE RISK PRICE RISK MANAGEMENTMANAGEMENT

WEATHER RISK WEATHER RISK MANAGEMENTMANAGEMENT

LOWER LOWER EARNINGS EARNINGS

VOLATILITYVOLATILITY++

Non-catastrophic weather risk impacts volume

Less volatility equals greater value

U/H H

Earnings $75 M $73 M

EPS $0.75 $0.73

Multiple 8x 9x

Stock Price $6.00 $6.57

Market Cap $600MM $657MM

Debt $100 M $100 M

COD 8.00 % 7.90 %

Debt Svc $8.0MM $7.9MM

Historical Revenues

UNHEDGED Expected Revenues

Without Weather Protection

$75 Million

HEDGED Expected Revenues

With Weather Protection

$73 Million

Reducing the volatility due to weather has a budget cost but increases returns per unit of risk and can potentially improve stock valuations and the cost of/access to financing.

Who buys weather risk management products? Agriculture Crop yield, handling, storage, pests

Construction Delays, incentive/disincentive clauses

Energy Reduced and/or excessive demand

Entertainment Postponements, reduced attendance

Governments Budget overruns

Insurance Increased claims, premium diversification

Manufacturing Reduced demand, increased raw material costs

Offshore Storm frequency/severity

Retailing Reduced demand of weather-sensitive products

Transportation Budget overruns, delays

Element Re founded

April 2000

1997 2003

First weather trades 1997

CME weather contracts open

Sept 1999

Element Re renamed XL Weather &

Energy February 2003

A$25mm rainfall (hydro) Sep 2002

€750mm Frost DaysConstruction

First market maker on CME

Feb 2002

First meeting of WRMA 1999

First weather risk bond issued

November 1999

International trading begins

In 2004, 122,000 weather risk management contracts have traded on the Chicago Mercantile Exchange, with 70,000 thus far in 2005.

£40mm temp (utility) 2002

CME offers a total of 20 Urban Temperature Indices

20011999

USD$30mm Syndicated Winter

Basket Issue

Evolution of the weather market

Weather market landscape – 2005

End Users

Generators

Distributors

Energy

Construction

Agriculture

et al

Insurance brokers

Banks

Inter-dealer brokers

Consultants

OTC

CME

Insurers & Banks

Energy Companies

Investors

Reinsurers

Retail

Intermediaries Primary Secondary Tertiary

Major market participants• ABN Amro (London) • Centrica (London)• Coriolis Asset Management (London)• Credit Suisse First Boston (New York)• DE Shaw (Kansas City)• Deutsche Bank (London)• Goldman Sachs (NYC) • Guaranteed Weather (Kansas City)• Merrill Lynch Commodities (Houston)• Ritchie Capital (Chicago) • Swiss Re (NYC)• TXU (Dallas)• XL Weather & Energy (Stamford)

Active & growingActive & growing

Newly openingNewly opening

World weather markets

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1998/9 99/00 2000/1 2001/2 2002/3

Number of Reported Contracts(No CM E T rades)

W inter

Summer695

3,397

2,759

1,285

4,517

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1998/9 99/00 2000/1 2001/2 2002/3

Total Survey Notional Value(m illions of dollars)

CM E

W inter

Summer

1,836

4,339

2,5173,003

4,188

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

Share of Total Contracts by Type(No CME Trades)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1998/9 99/00 2000/1 2001/2 2002/3

OtherRainOth TempCDDHDD

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

Number of Contracts by Region(No CM E Trades)

0500

1,0001,5002,0002,5003,0003,5004,0004,5005,000

1998/9 99/00 2000/1 2001/2 2002/3

Other

Europe

Asia

N. Amer. South

N. Amer. East

N. Amer. Midwest

N. Amer. W est

2001 SurveyN=19

2003SurveyN=19

2002SurveyN=20

PWC WRMA survey – 2003 results

XL Weather and Energy (XLWE) is the preeminent global weather risk management solutions provider, offering insurance, reinsurance and financial instruments. XLWE and its parent company - XL Capital - are dedicated to the long-term growth and development of weather risk management applications.

o Established leader in weather market• Founded as Element Re by weather industry pioneers

• Leader in market share and product development

• Offices in Stamford, Kansas City, London, and Bermuda (20+ staff total)

o Financial strength and network of XL Capital• Wholly owned subsidiary of XL Capital (Bermuda), within the Financial

Products & Services division

• XLWE is agent for XL Trading Partners, majority-owned affiliate of XL Insurance (Bermuda) Ltd.

XL Weather & Energy

XL voted #1 dealer in weather swaps for 2003 by RISK magazine

XL Capital

Insurance FinancialReinsurance

Indian Harbor

XL Insurance of NY

XL Specialty

(Admitted and E&S)

Potential counterparties that offer weather risk protection include:

XL Weather & Energy Ltd XL Trading Partners

XLWE business unit resides in this division

XLWE within XL Capital

International insurance, reinsurance, and financial products operations

• Publicly traded since 1991 as XL on the NYSE

Financial resources and stability recognized by rating agencies

• Standard & Poor’s financial strength rating of AA-

• Best’s claims-paying rating of A+

Liabilities $33.8B

Assets $40.8B

Equity $7.0B

XL Capital

Market Capitalization of $10.6B as of February 2005

BACKGROUND

The Almost Heaven Gas Company sells propane to residences throughout West Virginia. Recently, it has come under fire from the analyst community due to the severe annual earnings volatility it has experienced due to variable weather.

CHALLENGE

Within the next year, it must refinance the majority of its outstanding debt. With the increased scrutiny that Almost Heaven has been under, the CFO is concerned that the future cost of debt could greatly reduce the earnings potential of the company.

SOLUTION

The CFO feels there could be significant savings in the cost of debt if Almost Heaven were to eliminate its weather-driven earnings volatility. He undertakes to implement a weather risk management program before the upcoming winter to demonstrate to the analyst community that Almost Heaven has proactively taken steps to improve the quality of its earnings.

Almost Heaven…West Virginia

The four steps to hedge design

0

20

40

60

80

100

120

Apr May Jun Jul Aug Sep

Avg Temp Revenue

1 - Identify significant business exposure(s) to weather

2 - Quantify the impact of adverse weather on business

3 - Structure a contract that pays when adverse weather events occur

4 - Execute contract in optimal form to address business concerns

Coverage LayerAH XL

premium

coverage

Identify exposure – what is the hedging index?

Weighted Heating Degree Days (WHDDs)• Proxy for propane demand over heating season• Like demand, cannot be negative• Can construct a weighted index with individual components

Ex 50% Charlestown/50% Morgantown

1. Set baseline temperature TB and daily condition

Average temperature < 65o

2. Measure daily HDDs

If Tavg < 65o, then daily HDD = 65o - Tavg

If Tavg > 65o, then daily HDD = 0

3. Aggregate over season

Simply sum daily HDDs

Weighted heating degree day example

DATEC’town

Tavg

C’townHDDs

M’town Tavg

M’townHDDs

DAILYWHDDs

SEASONAL

WHDDs

Nov 1 60O 5 56O 9 7 7

Nov 2 59O 6 55O 10 8 15

Nov 3 65O 0 61O 4 2 17

Nov 4 70O 0 66O 0 0 17

2766

3978

o Identify best historical yearo Identify worst historical yearo Divide difference by difference in HDDso Apply margin per gallono Product is hedge notional (tick)

Quantify impact – what is the hedge notional?

44,233,98732571994

45,900,00033471995

44,100,0001996

55,600,00039651997

49,700,00036851998

50,400,00033601999

47,500,00033762000

55,700,00039342001

56,400,0002002

44,800,00032192003

GallonsWHDDYear

2500

3000

3500

4000

4500

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

40,000,000

45,000,000

50,000,000

55,000,000

60,000,000

HDDs Gallons

HISTORICAL HDDS AND PROPANE SALES

2002 had 3978 HDDs

1996 had 2766 HDDs

12,300,000/1212 =~10,000 Gallons/HDD

$1/Gallon

$10,000/HDD

BEST YEAR/WORST YEAR APPROACH

(GALLONS / HDD) x ($ / GALLON) = $ / HDD

Correlation = 92%

1. Wing It• Exposed to both downside pain and upside gain

• No hedge cost; just cost of not hedging

2. HDD Put• Protect downside/enjoy upside

• Up-front premium

• No credit necessary

3. HDD Swap/Collar• Protect downside/limit upside

• No/low premium

• Must be creditworthy

Structural alternatives

MARGIN CHANGE VS HDDS

($15,000,000)

($10,000,000)

($5,000,000)

$0

$5,000,000

$10,000,000

$15,000,000

2000

2100

2200

2300

2400

2500

2600

2700

2800

2900

3000

3100

3200

3300

3400

3500

3600

3700

3800

3900

4000

4100

4200

4300

4400

4500

4600

4700

4800

4900

5000

HDDs

MA

RG

IN C

HA

NG

E

SLOPE = $MARGIN/HDD

NO

RM

AL

Margin unhedged


($15,000,000)

($10,000,000)

($5,000,000)

$0

$5,000,000

$10,000,000

$15,000,000

2000

2100

2200

2300

2400

2500

2600

2700

2800

2900

3000

3100

3200

3300

3400

3500

3600

3700

3800

3900

4000

4100

4200

4300

4400

4500

4600

4700

4800

4900

5000

HDDs

MA

RG

IN C

HA

NG

E

NO

RM

AL

RE

TE

NT

ION

PUT

HEDGED

Margin hedged with put


($15,000,000)

($10,000,000)

($5,000,000)

$0

$5,000,000

$10,000,000

$15,000,000

2000

2100

2200

2300

2400

2500

2600

2700

2800

2900

3000

3100

3200

3300

3400

3500

3600

3700

3800

3900

4000

4100

4200

4300

4400

4500

4600

4700

4800

4900

5000

HDDs

MA

RG

IN C

HA

NG

E

NO

RM

AL

- S

TR

IKE

+ S

TR

IKE

COLLAR

HEDGED

HEDGED

COLLAR

Margin hedged with collar

Building a termsheet

1. IDENTIFY

Location: In what cities or markets is AHGC at risk to the weather? What are the weightings of each city’s contribution to total sales / margin if the decision is to create a basket?

Statewide, but best represented by Charlestown and Morgantown

Index: What weather measurement is the most accurate proxy for the exposure? Average, minimum, maximum, event or cumulative? What is the basket weighting?

Seasonal WHDDs (650F) = 50% Charleston + 50% Morgantown

Period: What is the critical risk period for AHGC? Seasonal, annual, or multi-year?

November 1st through March 31st

2. QUANTIFY

Notional: What is AHGC’s weather exposure per unit of the above index? This usually corresponds to margin/revenue lost per unit.

$10,000 per WHDD

Limit: What is the total amount of protection that AHGC requires per business period above?

$4,000,000

Building a termsheet (continued)3. STRUCTURE

Type: Is the protection required an index guarantee (ie put/call) or an index exchange (swap/collar)?

Put (Index Guarantee)

Retention: This is the index level where the weather protection “attaches” -- should be set as a function of the amount of weather risk that AHGC wishes to retain, and is a key part of pricing.

300 WHDDs = $3,000,000

Pricing: Premium payable to XL for the coverage provided as well as payment terms (upfront, periodic, arrears, etc) is a function of Expected Value + Risk Margin.

$1,500,000

4. EXECUTE

Re/Insurance or Derivative: Depends on company structure, location of exposure on financial statements, tax, use of captive insurer, desired location of recovery, and many other issues.

Insurance

Once the solution has been structured and priced to AHGC requirements, XLWE would obtain an order on behalf of AHGC to bind coverage with the appropriate XL Capital entity.

BACKGROUND

Dry Creek Hydro Electric generates electricity from its dam on the American River, south of Sacramento CA. The private equity firm that owns Dry Creek – Hydro Partners – plans to IPO the company within the next 12 months and wants to stabilize as much as possible the company’s cashflows.

CHALLENGE

Dry Creek has sold its entire 100MW capacity forward for the next five years via a fixed-price power price agreement with the Modesto Municipal Utility District (MMUD). While it has achieved price certainty on its expected generation, it must ensure that it has enough water to deliver on its commitment or face the prospect of purchasing expensive replacement power in the secondary market.

SOLUTION

Hydro Partners decides to pursue a five year “generation hedge” in the form of low precipitation cover indexed at Sacramento, its main watershed. It feels that the earnings stability this hedge provides should create high-quality returns that will attract investors to Dry Creek’s upcoming IPO.

Dry Creek Hydro Electric

The structuring model reflects three sets of variables:

Index…Notional…Structure

Weather Event

TriggersImpact

Definition of poor weather

Seasonal accumulation of water-equivalent precipitation in the key watershed

CoverageStructure

Effects of poor weather

Given shortfall in precipitation, % drop-off in revenue or increase in costs:

• Less generation

• Replacement power at wholesale cost

Effects of protection

Risk retained and limit of risk transferred, across all exposures

• Premium costs

• Historical effectiveness

Create an intuitive hedge – express inches of precipitation as potential MW of generation and apply a dollar value.

Shaping a hydro hedge over time

2004 20072008

2005 2006base

high mark

low mark

Structuring Inputs:oPrecipitation thresholds (weighted by location/timing)

Positive if over base, negative if under base

oNotional amounts (revenue gained/lost) per inch of precipitation

oFinancial deductible amount (cumulative for year/period) Total gain / loss must exceed deductible to trigger payment (in either direction) Settlement can occur monthly, quarterly, annually, or over term

o Increased certainty of cash flows over time Lower financing costs/improved budget visibility

Downside Covered$12MM

Executable structure - precipitation collar

Dead Band, No Payouts

42”

55”

61”

77”

26”

Upside Pledged$12MM

Mean

Index (inches)

Hedge Objective: Eliminate exposure to shortfall in precipitation at key watershed

Period Oct 1 through Sep 30

Term 5 years

Index Cumulative Precipitation

Location Sacramento CA

Notional Tick $750,000 per inch

Notional Limit $12,000,000

Call Strike 61 inches

Put Strike 42 inches

Premium $1,600,000 per year

Rate-On-Line 13.3%

Final Settlement Date 09/30/2008

Start small…

NEW CUSTOMER POSITION

OPTIMAL HEDGE

POSITION

…but get big and diverse fast!

NEW CUSTOMER POSITION

OPTIMAL HEDGE

POSITION

A high-quality portfolio attracts high-quality risks like a global magnet and consistently delivers dollars.

Risk management is a state-of-the-art career…

INSURANINSURANCECE

DERIVATIVDERIVATIVEE

CAPITALCAPITAL

To be successful in today’s market, a practitioner must have a thorough understanding of each of these converging markets.

…but why consider it?

It’s intellectually interesting work and can be very creativeYou’ll make jokes about options and you’re mother will never understand what you do all day

It’s a truly global business that will enable you to live and do business all over the worldYou’ll spend a lot of time in airports with your phone glued to your head and miss a lot of the sights (“I hear there’s a big tower here in Paris.”)

You will make more money than most of your childhood friends (unless you went to high school with LeBron James)You’ll work long hours and soon realize that free time is not for sale

Risk management is growing increasingly important to every business and you should be able to have a long careerBusinesses can act very strangely where derivatives are concerned and you must engender the trust of your employer (ie no sleight-of-hand)

Different front office roles

BUSINESS HEAD

ORIGINATION PORT MGMT STRUCTURING RESEARCH

Wisdom from down the road

Differentiate yourself from the pack• Never go to an interview for a job you want without a leave-behind

that shows your interest and creative thinking

Always be conscious of what your CV is going to look like in a year

• Actively manage your career by choosing good roles

The early money is often not the best money• Be conscious of your shelf-life and build an experience base that is

portable and won’t allow you to fall too far

Learn to spot the trends in your organization• A good weatherman watches the prevailing winds

Repay career kindness by one day helping someone else who is where you were

If it seems to good to be true, it probably is.

Essential reading

o Fooled by Randomness (Nassim Taleb)

o Against the Gods (Peter Bernstein)

o Moneyball (Michael Lewis)

o Market Wizards Series (Jack Schwager)

o Trend Following (Michael Covel)

o The (Mis)Behavior of Markets (Benoit Mandelbrot)

o The Predictors (Thomas Bass)

o The Smartest Guys in the Room (McLean/Elkind)

o The New Financial Order (Robert Shiller)

o A Mathematician Plays the Stock Market (John Paulos)

o Every Berkshire Hathaway Annual Report

weather risk management

Documents

rainy weather

hot weather

book of weather risk

measurable weather index

observable weather event

xl weather energy

hydroqubecs greatest

cement demand