What to make of insurance regulators bid to define weather derivatives as insurance products.

It’s been a cold winter in the Northeastern US, so we’ve got weather on the mind. And whether its global warming that concerns them, or freezing tempatures, more firms are seeing weather as a risk to manage. This fact has not escaped the attention of risk management service providers (nor their regulators).

A growth industry? Indeed, a 2003 survey conducted by PwC for the Weather Risk Management Association (WRMA), covering April 2002 through March, indicates a threefold increase in the number of weather risk management contracts over the prior year (11,756, from 3,937). The notional value of these contracts, reported at nearly $4.2 billion, was down from $4.3 billion, but the growing number reflects a broader spectrum of users—e.g., its not just energy traders dealing amongst themselves.

The WRMA cites the US Department of Commerce estimates that nearly one-third of the US economy, or $3.5 trillion, is at risk due to the weather. Weather risk management contract growth outside the US suggests that similar proportions of economic value is at risk in other major economic regions too.

Weather derivatives pale in comparison to interest rate or FX derivatives contracts (with notional values of $121.8 trillion and $22.1 trillion, respectively, for OTC contracts alone in the first half of 2003, according to the BIS). However, as a growing market segment, it is one that the insurance industry does not want to cede to derivatives traders.

A controversial white paper. In this context, it is interesting that ISDA, representing the derivatives community, has sent a letter to the National Association of Insurance Commissioners (NAIC), the organization of US insurance regulators, seeking the opportunity to comment on “Weather Financial Instruments (Temperature):Insurance or Capital Markets Products?”, a draft white paper being circulated by the NAIC’s property and casualty working group.

Written by its US legal counsel Joshua Cohn, on his law firm’s letterhead (Allen & Overy), the January 6 ISDA letter references a phone call Mr. Cohn made noting how “ISDA is extremely concerned” and “that the mere existence of the draft [white paper] has raised substantial concern in the derivatives market.”

What are ISDA and the derivatives market so concerned about? No doubt, it is the paper’s conclusion: “These weather derivatives and other "non-insurance" products are primarily temperature protection coverages (heating and cooling degree days) that appear to be disguised as "non-insurance" products to avoid being classified and regulated as insurance products.”

As a result: “The insuring public is missing out on many solvency and market regulatory benefits that state insurance regulation provides. States are missing out on premium tax revenues and the purchaser does not have the benefit of knowing that adequate reserves are maintained and monitored for solvency purposes. There also appears to be substantial misinformation in the reinsurance markets related to these products”.

This puts the NAIC at odds with the informal opinion (February 15, 2000) of the New York State Insurance Department General Counsel: “Weather derivatives do not constitute insurance contracts . . . because the terms of the instrument do not provide that, in addition to or as part of the triggering event, payment to the purchaser is dependent upon that party suffering a loss.” To an considered “insurance,” accordingly, the amount of the obligation, or the trigger to pay, would be based on a loss event.

Derivatives accounting. Defining contracts as derivatives or insurance, also has important accounting implications. In the gear up to FAS 133, many insurance firms sought an opening to offer hedging “insurance contracts” that would fall outside the scope of fair value or hedge accounting requirements. Most of these efforts were ultimately thwarted; however, there remained the scope out for non-exchange-traded contracts where settlement is based on “a climatic or geological variable or other physical variable.”

This issue came up again last year, when the IASB sought to eliminate this scope out in IAS 39, with a proposed IFRS for insurance contracts (ED 5). The July Exposure Draft proposed that weather derivatives should be brought within the scope of IAS 39 unless they meet the proposed definition of an insurance contract [emphasis added](paragraph C3 of Appendix C of the draft IFRS). It asked for comment on why this would or would not be appropriate.

The NAIC response was that they should not be, which would be consistent with the insurance industry’s desire to have a “leg up” on its competitors offering “derivatives” from an accounting and regulatory standpoint. If they lose the scope out for weather derivatives, the NAIC may believe that it can succeed in defining them as insurance (and scope them out that way).

Treasurers beware. For treasurers who view regulated insurance markets as a mug’s game, derivatives based on market pricing of risk may be preferable, even with the adverse accounting consequences.

And who’s to say the NAIC would limit its controversial white paper thinking to weather contracts? While everyone can agree on the benefits of alternative risk transfer offerings by insurers, those should be offered based on their economic merits, not regulatory preferences.