Weather derivative contracts impacted by unusually warm winter

Some weather derivative contracts have been impacted by the unusually warm winter conditions seen in the fourth-quarter of 2015 and which have continued into this year, with January 2016 seeing more temperature records broken.

There are a number of reinsurance players with weather risk management and weather derivative units, as well as some insurance-linked securities (ILS) players which also provide weather risk management capacity and invest in weather linked reinsurance deals.

With global temperatures rising over recent years and the winter of 2015 seeing a return to much milder conditions in many regions of Europe and the U.S., compared to the last few winters which had seen particularly cold spells (especially for the U.S.), some of these players have been impacted.

Companies such as energy or electricity providers often buy weather hedges in order to protect them from volatility in terms of warmer or cooler than expected or forecast weather conditions. In the winter of 2015 a number were able to make claims on their weather hedges, often weather derivative based, as the milder than normal weather saw average temperatures breaching contract triggers.

Star Gas Partners L.P., a company selling heating and air conditioning services and supplies, was one such firm, reporting that it recorded a $12.5 million credit from its weather hedging in the fourth-quarter of 2015.

In Star Gas Partners’ case, this will be a hedge against warmer winter weather which naturally reduces demand for its heating products. The firm likely also hedges its weather exposure in the summer as well, hedging the cold in that case as it will reduce its customers use of air conditioning.

The risk capital backing this type of weather derivative hedging contracts often comes from some of the world’s major reinsurance firms, or a number of ILS fund managers that also operate in the weather risk transfer space. As a result of the warmer than normal weather conditions there will have been some impact to a number of these players.

In fact, in its fourth-quarter earnings call, specialty insurance and reinsurance player Endurance revealed some impact due to the warmer weather, with an $8 million loss on weather contracts exposed to the warmer than normal European weather.

Endurance said that a significant portion of that exposure was reinsured, however, enabling it to book a lower net loss figure and that it was too early at that stage to identify whether the warmer weather seen in late January would have an additional impact.

Meanwhile AXIS Capital also revealed that the warmer European winter weather had hit the firm in Q4, with CFO Joe Henry saying that a $15 million loss in the firms other insurance segment was “driven by realized losses and mark to market adjustments on our reinsurance weather derivatives portfolio following unseasonably warm weather conditions in Europe.”

When asked how the firm thinks about the volatility that the weather risk transfer business can have, as a line, CEO of AXIS Albert Benchimol said; “We still think that weather is increasingly being seen by a number of businesses, governments and different entities as a real risk to their enterprise. We think that over time it’s going to be an important line of business and we are building a strong franchise in that area.”

Globally temperatures maintained an above average level in January 2016 according to NASA, after an initial colder period, so it will be interesting to see whether any further reports of losses on weather derivative books emerge at the end of this quarter.

The weather risk management business remains an opportunity for the ILS sector, with its parametric or weather-index triggers often seen as complementary to peak catastrophe risks. A number of players are very active in this space, both in the provision of weather hedges as well as more complex collateralised weather reinsurance solutions.

Buying weather protection and hedging the impacts of inclement weather is set to increase as a trend, be that as insurance or in derivative form. Those who develop the expertise to help large corporations to better manage weather exposure and volatility could be very strongly positioned to capitalise in future.