Charles C. Yang

WEATHER DERIVATIVES AND WEATHER RISK MANAGEMENT

Weather derivatives are a relatively recent kind of financial product developed to manage weather risks, and currently the weather derivatives market is the fastest-growing derivative market. The development of weather derivatives represents one of the recent trends toward the convergence of insurance and finance. This article presents an overview of weather risks, weather derivatives, and the weather derivatives market, and examines the valuation of weather derivatives in an incomplete market, the hedging effectiveness of standardized weather derivatives, as well as optimal weather hedging with the consideration of basis risk and credit risk.

Portfolio Effects and Valuation of Weather Derivatives

In a mean-variance framework, the indifference pricing approach is adopted to value weather derivatives, taking account of portfolio effects. Our analysis shows how the magnitude of portfolio effects is related to the correlation between weather indexes and other risky assets, the correlation between weather indexes, and the payoff structures of the existing weather derivatives in an investors asset portfolio. We also conduct some preliminary empirical analysis. This study contributes to the weather derivative pricing literature by incorporating both the hedgeable and unhedgeable parts of weather risks in illustrating the portfolio effects on the indifference prices of weather derivatives.

Pricing Weather Derivatives Using the Indifference Pricing Approach

Abstract This paper adopts an incomplete market pricing model–the indifference pricing approach–to analyze valuation of weather derivatives and the viability of the weather derivatives market in a hedging context. It incorporates price risk, weather/quantity risk, and other risks in the financial market. In a mean-variance framework, the relationship between the actuarial price and the indifference price of weather derivatives is analyzed, and conditions are obtained concerning when the actuarial price does not provide an appropriate valuation for weather derivatives. Conditions for the viability of the weather derivatives market are examined. This paper also analyzes the effects of partial hedging, natural hedges, basis risk, quantity risk, and price risk on investors’ indifference prices by examining the distributional impacts of the stochastic variables involved.

Basis risk and hedging efficiency of weather derivatives

Purpose - The purpose of this paper is to examine empirically the basis risk and hedging efficiency of temperature-indexed standardized weather derivatives in hedging weather risks in the US energy industry. Design/methodology/approach - Within the risk minimization framework, using power load and temperature data, this research analyzes both linear and nonlinear hedging strategies using the two most popular types of standardized indexes – city indexes and regional indexes. Findings - The results indicate that the city indexes and regional indexes are not consistently superior to each other and the regional indexes should be a good complement to the current exchange-listed indexes. The results also document that the basis risk is sufficiently low for the diversified power producers serving the US Northeast or Mid-Atlantic regions in both the summer and winter seasons and California in the summer season. However, the basis risk is very high for the diversified power producers serving California in hedging the weather risk in the winter season. More discrepancies are observed in the hedging efficiency among the power producers serving the Texas region. Originality/value - This research provides important implications about the survivability and superiority of current and proposed standardized weather contracts and the design of effective standardized weather derivatives for the extant and potential weather markets.

Catastrophe effects on stock markets and catastrophe risk securitization

Purpose - Conventional wisdom states that catastrophe risk securities show no or little correlation with stock and bond markets, and offer significant attractions to investors providing a good diversification of risks. This study examines the correlation between catastrophe risk securities and portfolios of other equities by analyzing catastrophe effects on the Japanese stock market. Design/methodology/approach - Using catastrophe data from SwissRe Sigma publications and stock returns from the Pacific-Basin Capital Markets database, this paper analyzes stock and abnormal returns in the Japanese stock market using event study methodology. Findings - For the Japanese stock market as a whole, there is no significant catastrophe effect. The results indicate a significant negative correlation between catastrophe loss amount and the insurance industrys equity returns and abnormal returns, a significant positive correlation with the construction industry, but no significant correlation with the real estate industry. This paper also analyzes the impact of catastrophe causalities. The results show little evidence on the significance of these variables. Originality/value - This study provides important insights to the insurance/reinsurance industry in the Japanese risk market for catastrophe property and mortality risk securitization and to investors who are interested in further improvement of their portfolio risk/return profile by including catastrophe risk securities.

Health Care Reform, Efficiency of Health Insurers, and Optimal Health Insurance Markets

This research uses the input-oriented Data Envelopment Analysis (DEA) approach to examine the efficiency of the U.S. health insurers. It shows that more insurers are less efficient than the previous sample year; however, the results suggest that the federal health care reform have no significant effect on the overall efficiency of all the insurers as a whole which is very low but does not change much over time. This research explores how to improve the efficiency of the health insurance market by proposing the state, regional and national efficiency-based goal-oriented market models and an efficiency duplicating system, and discusses important implications to the health care compacts, the health insurance exchanges or marketplaces, and the national multi-state programs. It also analyzes further moves for efficiency enhancement with regard to payments methods and the health care delivery system. One interesting finding is that the Medicaid program is very efficient as provides support to the offering of Medicaid coverage and further expansion which enhances the health welfare of the society with fewer resources inputs from the perspective of efficiency. This research should provide important insights for the state and federal governments, policy makers, regulators, the health insurance industry, and consumers.

The Dynamic Interactions between Risk Management, Capital Management, and Financial Management in the U.S. Property/Liability Insurance Industry

This study examines empirically how risk management, financial management, and capital management are related to each other in the property/liability insurance industry, thereby reflecting interactions in managerial decisions such as the choice of derivatives and reinsurance use, the allocation of asset risks, the determination of underwriting activities and liability risks, and the adequacy of capital levels. This research contributes to the literature by adopting structural equation modeling to capture not only the dynamic interactions among capital management, financial management, and risk management, but also the effects of internal integrated factors or external regulatory factors on these managerial decisions. Among the empirical findings of this study, it is shown that risk management, capital management and financial management should be assessed under an integrated framework as emphasized in the concept of enterprise risk management. In addition, regulatory requirements embedded in the insurance industry might play an essential role in the integration of managerial decisions.

The Effectiveness of Using a Basis Hedging Strategy to Mitigate the Financial Consequences of Weather-Related Risks

Abstract This paper examines the effectiveness of using a hedging strategy involving a basis derivative instrument to reduce the negative financial consequences of weather-related risks. We examine the effectiveness of using this basis derivative strategy for both summer and winter seasons, using both linear and nonlinear hedging instruments and the impacts of default risk and perception errors on weather hedging efficiency. We also compare the hedging effectiveness obtained using weather indices produced by both the Chicago Mercantile Exchange (CME) and Risk Management Solutions, Inc. (RMS). The results indicate that basis hedging is significantly more effective for the winter season than for the summer season, whether using the CME or RMS weather indices, and whether using linear or nonlinear derivative instruments. It is also found that the RMS regional weather indices are more effective than the CME weather indices, and the effectiveness of using either linear or nonlinear hedging instruments for weather risk management can vary significantly depending on the region of the country. In addition, the results indicate that default risk has some impact on nonlinear basis hedging efficiency but no impact on linear basis hedging efficiency, and reasonable perception errors on default risk have no impact on either linear or nonlinear basis hedging efficiency.

Weather derivatives, price forwards, and corporate risk management

Purpose - The paper aims to examine theoretically valuation of weather derivatives and their hedging roles in corporate risk management. Design/methodology/approach - The paper introduces an extended financial market model in which the weather risk is included as an independent random process and examines the effectiveness of weather derivatives and traditional price forwards in a unified theoretical framework. It also provides a no-arbitrage approach to price weather derivatives, which theoretically combines the actuarial and financial paradigms. Findings - The results document that corporate leverage level is an essential factor determining the choice between price forwards and weather derivatives. In some cases; weather derivatives outperform price forwards, while in some other cases; a joint use of both instruments is optimal, depending on the firms risky leverage level. Interestingly, the paper identifies the case when the leverage level is very high, the positive roles of both instruments diminish and the firm is unhedgeable. Originality/value - The paper provides important insights to investors and hedgers and extends the literature on corporate risk management.

An Efficiency-Based Approach to Determining Potential Cost Savings and Profit Targets for Health Insurers: the Case of Obamacare Health Insurance CO-OPs

This research analyzes the performance of the health insurance consumer-operated and -oriented plan (CO-OPs), examines their medical services and operating efficiency, proposes an efficiency-based goal-oriented approach for cost reductions, profit targets, premium changes, and government subsidies, and provides an important guide for improvement potentials for both the CO-OP health insurance model and other health insurers. The CO-OPs are not satisfactory in the medical services efficiency, and they are much less efficient compared with other insurers. Potential cost reductions are significant using various (conservative) efficiency goals. Most CO-OPs suffer underwriting losses, as do many other insurers; a few CO-OPs are much more operating efficient than other insurers, but all CO-OPs need significant improvement of financial performance relative to benchmark insurers. Incorporating potential cost reductions, many CO-OPs would barely require any “premium changes and government subsidies,” and they are e...