The weather derivatives market has been growing steadily with data from the Weather Risk Management Association (WRMA) showing that the overall market grew by 20% in the 2010 to 2011 year to a total size of $11.8 billion. The WRMA said that the OTC weather derivatives market alone is worth $2.4 billion. With numbers like those in play it’s surprising that we haven’t seen more attempts to securitize those risks and transfer them to the capital markets.
Of course the weather risk market also includes significant sums of re/insurance, probably much larger than the amount of weather risk deals the WRMA counts. Many weather insurance policies are now measured and triggered based on indices of weather data in a similar manner to derivatives transactions. Insurers and reinsurers are assuming more and more weather risk through these policies and now we have the explosion of microinsurance schemes which also use weather indices to measure and trigger policies for customers in emerging markets. In simple terms, what this means is that there is a large amount of insurance risk which is linked to measurable weather conditions, which, when added to the weather derivatives, futures and options markets, you would think equals plenty of risk for a securitization market to flourish.
Weather risk securitization is a risk transfer concept which never really took off. The first companies to attempt to transfer their weather risks to capital markets investors were the likes of Enron and Koch Energy Trading. These two were involved in the very first weather derivatives transactions and in 1999 attempted to transfer some of the weather risks they held in derivatives to the capital markets.
Both deals were similar to the insurance-linked securities transactions we see today for catastrophe bonds and other non-financial risks. Koch attempted to issue a three-year deal which bundled the risks from a portfolio of 28 weather derivative contracts worth $227m, but due to a lack of investor demand ended up placing just $50m in the capital markets. Enron meanwhile attempted to issue a $105m weather bond but withdrew the offering because of a lack of interest from investors.
So why did these fail? Investors tell us that it was too early, the catastrophe bond market was only just really getting started and transfer of weather and catastrophe risks was a new concept to investors. One investor we’ve discussed this with was approached to participate in Koch’s deal but said that they felt the counterparty risks were too high, this was before total return swaps were thought to be too risky to use. There were also questions about the quality of weather data and reporting mechanisms, but again this was early days in the weather risk and risk securitization markets.
We’re not sure whether anyone is currently using securitization to transfer their weather risks to investors. It is possible that some private deals are transacted which take weather derivative risk and bundle them into a cat bond type structure.
The ILS market is maturing, investors are extremely comfortable assessing non-financial risk securitization and have an appetite for these assets which have low correlation to the financial markets. The questions around counterparty risk are also less of an issue now that new ways to collateralise transactions have been devised which remove the risk of counterparty failure and an inability to pay premiums and principal. Also the questions around weather data are mostly a moot point as both the techniques for collection of data and the real-time reporting of weather conditions which are now available ensure a decent level of transparency of risk. So it is surprising that we haven’t seen an attempt to repeat the kind of weather bonds that Koch and Enron both tried to issue in 1999.
With so much risk linked to measurable weather conditions and weather indices in the re/insurance market, and re/insurers exposure to these risks growing as weather-index insurance expands around the globe, it seems logical that someone will attempt to securitize weather risk in the future. With readily available weather data from which indices and triggers can be derived it’s also surely only a matter of time until corporates with large amounts of weather exposure try to transfer that risk to investors as securities rather than using derivatives.
We’re interested to hear your opinions on weather risk securitization. Are there specific reasons you believe this has never taken off? Can you see a way these risks could be issued effectively? Do you think investors would want these risks? Is this already happening on a private placement basis? Please let us know your thoughts in the comments below.