Weather Risk Management

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Weather Risk Management
UNIVERSITY of HOUSTON February 24, 2005
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• Weather risk affects a broad cross-section of
  global businesses in a variety of ways.

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• Read how some of these companies describe their
  exposure

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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 Companys 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.

Both 1997 and 1998 fiscal results were impacted
by extremely harsh winter patterns that flooded
over 41,000 acres of the Companys 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.
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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.

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.
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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.
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HYDRO QUEBEC HUGE NA GENERATOR

• Major variation in runoff is Hydro-Québecs
  greatest risk, since 93 or our electricity is
  generated from hydropower Significant
  temperature variances have an appreciable impact
  on seasonal demand.

Major variation in runoff is Hydro-Québecs
greatest risk, since 93 or our electricity is
generated from hydropower Significant
temperature variances have an appreciable impact
on seasonal demand.
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• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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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.
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Types of weather risk
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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.
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Current weather market index complex

• Risks
• Temperature (F/C) Minimum, Maximum or Average
• Precipitation Rainfall and Snowfall
• Combinations Dual Trigger Products
• Measurement and Indices
• Critical 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)

Key is acceptable historical data and ongoing
measurement
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Non-catastrophic weather risk impacts volume
PRICE
VOLUME
REVENUE
x

PRICE RISK MANAGEMENT
WEATHER RISK MANAGEMENT
LOWER EARNINGS VOLATILITY

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Less volatility equals greater value
Historical Revenues
UNHEDGED Expected Revenues Without Weather
Protection75 Million
HEDGED Expected Revenues With Weather
Protection73 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.
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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

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• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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Evolution of the weather market
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Weather market landscape 2005
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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)

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World weather markets
Active growing
Newly opening
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PWC WRMA survey 2003 results
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• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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XL Weather Energy
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.

• 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)
• 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 voted 1 dealer in weather swaps for 2003 by
RISK magazine
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XLWE within XL Capital
XL Capital
Financial
Reinsurance
Insurance
Potential counterparties that offer weather risk
protection include

• XL Weather Energy Ltd

• XL Trading Partners
• XLWE business unit resides in this division

• Indian Harbor
• XL Insurance of NY
• XL Specialty
• (Admitted and ES)

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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 Poors financial strength rating of
  AA-
• Bests claims-paying rating of A

Market Capitalization of 10.6B as of February
2005
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• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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Almost HeavenWest Virginia

• 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.

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The four steps to hedge design
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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

• Set baseline temperature TB and daily condition
• Average temperature
• Measure daily HDDs
• If Tavg
• If Tavg 65o, then daily HDD 0
• Aggregate over season
• Simply sum daily HDDs

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Weighted heating degree day example
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Quantify impact what is the hedge notional?
HISTORICAL HDDS AND PROPANE SALES
Gallons
WHDD
Year
44,800,000
3219
2003
3978
56,400,000
2002
55,700,000
3934
2001
47,500,000
3376
2000
50,400,000
3360
1999
49,700,000
3685
1998
55,600,000
3965
1997
2766
44,100,000
1996
45,900,000
3347
1995
44,233,987
3257
1994
Correlation 92
BEST YEAR/WORST YEAR APPROACH

• Identify best historical year
• Identify worst historical year
• Divide difference by difference in HDDs
• Apply margin per gallon
• Product is hedge notional (tick)

2002 had 3978 HDDs 1996 had 2766
HDDs 12,300,000/1212 10,000 Gallons/HDD 1/Gallo
n 10,000/HDD
(GALLONS / HDD) x ( / GALLON) / HDD
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Structural alternatives

• Wing It
• Exposed to both downside pain and upside gain
• No hedge cost just cost of not hedging
• HDD Put
• Protect downside/enjoy upside
• Up-front premium
• No credit necessary
• HDD Swap/Collar
• Protect downside/limit upside
• No/low premium
• Must be creditworthy

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Margin unhedged
SLOPE MARGIN/HDD
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Margin hedged with put
PUT
HEDGED
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Margin hedged with collar
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Building a termsheet
1. IDENTIFY Location In what cities or markets
is AHGC at risk to the weather? What are the
weightings of each citys 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 AHGCs 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
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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.
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• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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Dry Creek Hydro Electric

• 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 companys
  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 Creeks upcoming IPO.

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IndexNotionalStructure
The structuring model reflects three sets of
variables

• Definition of poor weather
• Seasonal accumulation of water-equivalent
  precipitation in the key watershed

• 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.
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Shaping a hydro hedge over time

• Structuring Inputs
• Precipitation thresholds (weighted by
  location/timing)
• Positive if over base, negative if under base
• Notional amounts (revenue gained/lost) per inch
  of precipitation
• Financial 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
• Increased certainty of cash flows over time
• Lower financing costs/improved budget visibility

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Executable structure - precipitation collar
Hedge Objective Eliminate exposure to shortfall
in precipitation at key watershed
Index (inches)
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Upside Pledged 12MM
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Dead Band, No Payouts
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Mean
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Downside Covered 12MM
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43

• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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Start small
NEW CUSTOMER POSITION
OPTIMAL HEDGE POSITION
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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.
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• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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Risk management is a state-of-the-art career
CAPITAL
INSURANCE
DERIVATIVE
To be successful in todays market, a
practitioner must have a thorough understanding
of each of these converging markets.
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but why consider it?

• Its intellectually interesting work and can be
  very creative
• Youll make jokes about options and youre mother
  will never understand what you do all day
• Its a truly global business that will enable you
  to live and do business all over the world
• Youll spend a lot of time in airports with your
  phone glued to your head and miss a lot of the
  sights (I hear theres 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)
• Youll 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 career
• Businesses can act very strangely where
  derivatives are concerned and you must engender
  the trust of your employer (ie no
  sleight-of-hand)

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Different front office roles
BUSINESS HEAD
ORIGINATION
PORT MGMT
STRUCTURING
RESEARCH
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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 wont 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.

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Essential reading

• Fooled by Randomness (Nassim Taleb)
• Against the Gods (Peter Bernstein)
• Moneyball (Michael Lewis)
• Market Wizards Series (Jack Schwager)
• Trend Following (Michael Covel)
• The (Mis)Behavior of Markets (Benoit Mandelbrot)
• The Predictors (Thomas Bass)
• The Smartest Guys in the Room (McLean/Elkind)
• The New Financial Order (Robert Shiller)
• A Mathematician Plays the Stock Market (John
  Paulos)
• Every Berkshire Hathaway Annual Report

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• What is weather risk management?
• What is the weather market?
• Who is XL Weather Energy?
• Case Study I Almost Heaven Gas Company
• Case Study II Dry Creek Hydro Electric
• How do you manage a book of weather risk?
• Your career
• QA

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