Managing weather risk with financial market tools

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1 Managing weather risk with financial market tools

2 Weather events don t have to be catastrophic to hurt your business Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 2

3 Discussion objectives What we'd like to accomplish today Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 3

4 Swiss Re at a glance Who is speaking Swiss Re is a leading and highly diversified global reinsurer, founded in Zurich (Switzerland) in 1863 Headquarters, Zurich Armonk, New York The Gherkin, London 147 years of experience in providing wholesale re/insurance and risk management solutions. We deliver both traditional and innovative offerings in Property & Casualty and Life & Health that meet our clients needs. A pioneer in insurance-based capital market solutions, we combine financial strength and unparalleled expertise for the benefit of our clients. Our financial strength is currently rated: Standard & Poor s: AA-/stable; Moody s A1/stable; A.M. Best: A/positive Key statistics in USD bn FY 2009 FY 2010 Premiums earned: Net income: Shareholders equity: Return on equity: 2.3% 3.6% Return on investments: 1.8% 3.5% P&C combined ratio: 88.3% 93.9% L&H benefit ratio: 83.8% 88.7% Revenues by business (Total 2010: USD 19.7bn) Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 4

5 Swiss Re is a leader among the world's reinsurers Top ten reinsurers based on net premiums earned 2009 (USD bn) Munich Re* 31.2 Swiss Re 22.6 Hannover Re 13.0 Berkshire Hathaway* 12.5 Lloyd s* 9.0 SCOR 7.7 RGA 5.7 PartnerRe** 5.1 Trans Re 4.0 Everest Re 3.9 P&C (USD bn) L&H (USD bn) * reinsurance segment only. ** pro forma including including Paris Re 9M NPE of USD 0.9 bn Source: Swiss Re, Economic Research & Consulting Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 5

6 Why does Swiss Re hold weather risk? Swiss Re's diverse range of business Diversificatio n Non-catastrophic weather a small part of Swiss Re s overall insurance portfolio Weather uncorrelated to Swiss Re s other exposures Expertise World s largest reinsurer of catastrophe risk Extensive climate research experience Casualty eg 3rd party motor insurance, employers liability insurance16% Figures relate to premiums earned in 2010 Source: Swiss Re 2010 annual results Administration of closed life insurance books8% Client need Energy clients are a significant part of firm's corporate client base Significant expertise and a strong rationale to write weather protection Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 6 of 15

7 What kinds of businesses have exposures? Consumer Goods Travel and Leisure Retailing Construction Sales of beer or ice cream (eg) are highly correlated to temperature. Marketing specialists know the relationships very well, and use the data to manage their weather risk, often through supply chain relationships Tour operators use weather promotions to attract new business Resort business is affected by weather ski stations need snow; beach resorts need sunshine Weather drives foot traffic through shopping centers Retailers use promotions to push product Adverse weather limits work at outdoor sites, creating direct and indirect expenses for contractors All of these industries and more -- use weather protection to manage their exposures Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 7

8 Energy firms are particularly exposed Weather risk equals price exposure Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 8

9 How weather protection works Begin by creating or choosing an index Payout based on index levels provides recovery that hedges the risk HDD: The number of degrees below 18 Celsius in average temperature per day Limit 2500 Trigger point Weather Index CDD: The number of degrees above 18 Celsius in average temperature per day Customised Index: based on cumulative weather variables (temperature, precipitation, irradiation, etc) with a fixed payout per index unit. Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 9

10 From concept to term sheet Turning a need into a protection structure Cumulative yearly HDD Nov 30 Dec 30 Weather index Weather Station Heating Degree Day (HDD) Temperature Based - Heating Degree Day Birmingham, UK (Coleshill) The number of degrees below 18 Celsius in average temperature per day Risk period 30/11/ /12/2011 Notional Structure Payout Strike (Floor level) 490 HDD, which represents a 10-year return period for harsh UK winter 6,000 Tick value 120,000 per HDD Limit 6,000,000 Call Option Premium 675,000 annually Premium 490 HDD Call strike Seller pays 540 HDD Call Limit cumulative yearly HDD Nov 30 Dec 30 Description Protection Seller will pay Protection Buyer 120,000 for each HDD above the strike, subject to a maximum amount of 6,000,000 Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 10

11 What is in the recipe? Terms of a protection structure Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 11

12 Understand insurance? Then you understand derivatives Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 12

13 Market structure The players Protection Buyers Intermediaries Protection Sellers Banks Energy companies Other corporate buyers Insurers and reinsurers Proprietary traders Commodity brokers Insurance brokers "Aggregators" Insurers and reinsurers Specialised fund investors Energy companies Commodity and proprietary traders Direct bi-lateral placement This is largely an over-the-counter market, but for simple vanilla transactions, exchange trading also plays a role Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 13 of 15

14 Use by European Energy companies The market is growing At least 634 transactions reported in Total risk transferred in excess of $1.5 billion Energy companies represent large portion of this activity Number of OTC weather trades reported in Europe Source: Weather Risk Management Association, Industry sources Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 14

15 Case study Preserving a hedging strategy The client's situation UK gas supplier with large market share in home heating business Risk of severely cold or unusually warm winter has high impact on The client's needs Careful management of exposure to volatile gas prices imposed by board Desire for low volatility in operating earnings in business unit Natural interest in minimizing cash costs of hedging Weather market solution "Warm vs cold" swap with gas price trigger "Warm vs cold" swap with gas price trigger The client's benefits Efficient retention and financing of key risks. Preservation of integrity of price hedging to be faithful to market disclosure Low up-front cash outlay Efficient alternative to dynamic hedging alternatives Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 15

16 Representative transactions Recently closed deals, Swiss Re as protection seller Client Motivation Trigger and settlement Protection structure Risk Period Currenc y Limit UK retail gas supplier Integrity of price hedging Temperature/wind index and gas price Composite Weather Variable swap May 2011 Apr 2012 GBP 47,000,000 European power producer Avoid price spikes when cold drives demand up Heating Degree Days and tick value Heating Degree Day call option Nov 2011 Mar 2012 EUR 28,000,000 Dutch building industry Cover costs when worksite is too cold in winter "Frost Day", based on temperature and wind chill Critical day call option Nov 2011 Feb 2012 EUR International tour operator Sales promotion that includes a bet on snowfall Snowfall accumulation at named location Binary snowfall call option 1 Jan 2012 CAD 16,000,000 Australian power retailer Hedge risk of being short when demand is high Temperature and system load, power price settlement Temperature- and demand-triggered call option on power Nov 2011 Mar 2012 AUD 22,000,000 UK power producer Reduce extreme volatility in operating profits Temperature and gas price Temperature collar (offsetting put and call with dead zone) gas-settled Oct 2011 Mar 2012 GBP 18,000,000 German service company Hedge risk of excess snowfall in train stations Temperature and precipitation with fixed tick Call option on temperature/precipitation combination paying fised tick Dec 2010 Feb 2010 EUR 7,500,000 Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 16

17 Guide to structuring weather protection Attribute Definition How to determine Attachment point Payoff pattern Limit Type of protection The level of temperature or rainfall at which the protection buyer needs to be paid for the risk of profits not being realised Recovery formula once the protection is triggered. The recovery is either index points times a fixed unit cost or times a commodity price vs a strike The total amount of payoff the protection buyer can receive Swap fixes the level of revenue from an asset with a contract for differences Floor the most common structure, which establishes a minimum level of revenue Collar like a swap, but has both a cap and a floor Typically, the level at which cash flow failure becomes problematic Based on exposure: what happens when it's too warm and gas (eg) is very cheap? How much is needed to replace the economics of lost profits Economics and buyer preference Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 17

18 Why firms hedge Earnings stability creates shareholder value Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 18

19 Weather is typically underhedged Inconsistency in risk management policy Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 19

20 Hedging gives firms the ability to choose what level of exposure they have Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 20

21 Not all firms hedge this risk yet Typical objections and issues Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 21

22 Thank you Stuart Brown Swiss Re London Tel: +44 (0) Thomas Kammann Swiss Re Zürich Tel: +41 (0)

23 Legal notice 2011 Swiss Re. All rights reserved. You are not permitted to create any modifications or derivatives of this presentation or to use it for commercial or other public purposes without the prior written permission of Swiss Re. Although all the information used was taken from reliable sources, Swiss Re does not accept any responsibility for the accuracy or comprehensiveness of the details given. All liability for the accuracy and completeness thereof or for any damage resulting from the use of the information contained in this presentation is expressly excluded. Under no circumstances shall Swiss Re or its Group companies be liable for any financial and/or consequential loss relating to this presentation. Energy Risk Central & Eastern Europe Warsaw 10 November 2011 Stuart Brown, Swiss Re 23

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