Betting on stormy weather
Hurricane Sandy's churns off the coast of Florida as a line of clouds associated with a powerful cold front approaches on October 26, 2012 in the Atlantic Ocean.
Wherever there’s disaster, there’s also opportunity. Not to be grisly, but there is a small segment of the financial services industry devoted to the kind of event now battering the U.S. East Coast—a massive hurricane with unknown costs and consequences. It’s called ‘weather derivatives.’
Within the industry, they have exotic names: ‘catastrophic bonds,’ and ‘industry loss warrants.’ Basically, this is a hedge—a way for a company or industry to protect itself against financial hits from weather.
No one can predict individual storms like Sandy--at least not weeks or months ahead of time. But companies know Mother Nature is going to spring these things from time to time, according to Nick Ernst, director of weather markets at Evolution Markets in New York.
“Any weather event that is going to affect the bottom line, we have the ability to write a product to protect it.”
What Ernst’s firm will arrange is a kind of insurance. The derivative deal will offset a company's lost revenue from weather. In the case of a utility or ski area, that might be a winter warm snap that causes heating bills or lift-ticket sales to suddenly plummet. E-commerce and internet companies might try to insulate themselves from the cost of servers crashing in a huge storm blackout. And of course, there are property insurers, says Nick Ernst.
“The hurricane or large-storm market is a very large and liquid market, because there is so much property in the path,” says Ernst. “So if you look at Florida, the Gulf Coast, the insurers have taken on a lot of risk in those areas, and they try to take some of that risk off their books.”
The party on the other side of the weather-risk bet is likely to be a hedge fund, bank, or reinsurance company.
These players profit when big weather events don’t happen, because the companies that need protection from weather exposure pay a premium. These same banks and hedge funds might offset their own risk by buying a derivative that pays out after a storm, says Ernst.
The weather derivatives market is valued at $15 billion, according to an analysis by Pricewaterhouse Coopers, says Ernst. And it’s likely to grow as weather becomes more severe and costly.
For any company trying to hedge against losses from Sandy, it’s too late. Ernst says any storm that’s already “in the water,” can’t be hedged against anymore.