A Way for Investors to Weather Storm Damage

Wall Street offers a financial tool that allows traders to hedge the risk of weather-related business problems. Marianne Lavelle of U.S. News and World Report tells Madeleine Brand how weather derivatives work.

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MADELEINE BRAND, host:

The Eastern United States is facing billions of dollars of property damage and cleanup work after a week of thunderstorms and floods. Unpredictable weather can wreak havoc on all kinds of businesses, from farms to utility companies. Well, Wall Street has a tool to fight back: weather derivatives. They allow traders to hedge the risk of weather-related problems.

BRAND: Marianne Lavelle has written a story on weather derivatives for U.S. News and World Report. I asked her to explain how they work.

Ms. MARIANNE LAVELLE (Senior Editor, U.S. News and World Report): Well, I hope not to go into too much detail, because I'm afraid we'll all get lost. But I'll try to give you an example. Utility companies, they really count on having a nice and cold winter, so they can sell you a lot electricity, and a lot of - that you use a lot of natural gas. But if you have a warmer than usual winter, the way we did in the Northeast last winter, they're going to lose money. So what they do is they set up a deal with one of these big, big re-insurance companies. And they say if the number of heating degree days this winter goes below, say, 3800 for the whole season, I will be paid $5 million by you.

BRAND: So it's kind of like an insurance plan?

Ms. LAVELLE: It is so much like an insurance plan. But one thing that people said to me, over and over again, is these things are really pricey. The premiums up front are something like $100,000, and that's just for starters.

BRAND: Hmm. Well, is there any move at all to make them more available to the common person?

Ms. LAVELLE: This market has been around since about 1997. But it really has taken off in just the last year. Changes in weather are becoming more costly, because energy is so pricey. So a lot more people - a lot more businesses, really, are using weather derivatives. And then, the other thing is the weather has been very volatile. So now that the market is really growing, I think that you're going to see more and more widespread application of these weather derivatives.

BRAND: You write that weather derivatives can help humanitarian groups.

Ms. LAVELLE: Hmm.

BRAND: How is that?

Ms. LAVELLE: The deal that was done just a few weeks ago is the United Nations World Food Program worked out an arrangement with the French insurance company named AXA Re. And they will pay a premium of about a million dollars a year for the next three years. And they will get a payout of $7 million, if rainfall in Ethiopia is less than expected, if it gets into that danger zone that the World Food Program knows from years of experience means drought and hunger and disaster in that country.

BRAND: But, if it doesn't, they're out?

Ms. LAVELLE: They're out $3 million.

(Soundbite of laughter)

BRAND: Three million.

Ms. LAVELLE: It sounds to me like a very pricey premium, a million dollars a year for $7 million of protection. That seems pretty pricey to me. But there's no way - and this is one of the disadvantages of this - there's no way of really saying if that price is too high, because there's never been that kind of insurance policy written to address the drought risk of an entire nation. So again, this market is very, very new. And it's really hard to know if you're getting a fair price yet.

BRAND: Marianne Lavelle is a senior staff writer for U.S. News and World Report. Her story on weather derivatives is in the current issue.

Thank you, Marianne.

Ms. LAVELLE: Glad to be here.

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