According to the US Commerce Department, about 30% of the US GDP is impacted -- both directly and indirectly -- by the weather. Changes in the weather, quite literally, result in large scale changes in business results. This translates into unplanned for volatility that can disrupt even the best made plans.
Large companies with financial weather risk can manage the impact of weather on their sales and earnings in two fundamental ways:
1) operationally using forecasts and data and,
2) financially using weather derivative products to hedge (either via an exchange or over the counter) against weather related losses.
Trading hurricane futures and options to offset the financial risk associated with storms began a couple of years ago at the CME and is now -- following a very active year last year and in the face of predictions of another active season -- gaining significant traction.
Note the article below from today's Chicago Tribune:
CME Group sees hurricane contracts surge as season approaches:
The markets are literally bracing for a stormy 2009.
Futures
and options on hurricanes striking the American coastline have surged
after CME Group extended trading to the entire year, with the exchange
reporting a volume of 3,000 contracts several months before the start
of hurricane season.
The pace should easily eclipse the 32,600
contracts traded last year. It already blew past the 2007 volume, when
new hurricane contracts failed to notch a single trade.
The
latest increase isn't enough to offset average daily volume that is
down about 41 percent at the CME Group so far this month. Yet the
hurricane contracts show that a silver lining can exist when dark
clouds fill an economy.
Insurers traditionally spread the risk of hurricanes hitting businesses and homeowners by selling parts of their policies to a group of reinsurance companies.
Those reinsurance companies are beginning the year with strained balance sheets. Hurricanes Ike and Gustav wreaked as much as $31 billion worth of damage and the recession has restricted the availability of credit.
"A lot of our capital providers have been squeezed by the financial crisis, so they're not able to give us the reinsurance we need," said Steve Smith, president of property solutions for ReAdvisory, a division of the reinsurance broker Carvill.
The situation is severe enough that some firms chose to exit the reinsurance business. For example, Citadel Investment Group in Chicago is closing its division after its two largest hedge funds suffered losses of more than 50 percent last year.
Exchange-listed contracts can be more cost efficient than other financial instruments used by reinsurers because some of the risk is transferred to the CME Group clearinghouse.
The contracts are based on a storm's landfall and a rating of its strength according to wind speed and size. Carvill developed the ratings, because waiting to assess hurricane damage directly could delay settling the contracts by months.
Kendall Johnson, who trades the contracts as a managing director for Tradition Financial Services, said volume is improving because the industry has "seen how the product worked last year" and it is "more comfortable with it now."
Insurance companies probably need to be comfortable once hurricane season starts in June, given preliminary forecasts made by researchers at Colorado State University.
There is a 63 percent probability of a major hurricane striking the U.S. coastline this year. That annual probability over the last century has averaged 52 percent.
"When there are more storms out there, generally there's the greater chance of landfall," said Phil Klotzboch, one of the Colorado State researchers.
