Weather Risk Management

1. Weather Risk Management UNIVERSITYofHOUSTON February 24, 2005

2. Weather risk affects a broad cross-section of global businesses in a variety of ways.

3. Read how some of these companies describe their exposure…

4. JG BOSWELL – LARGEST US COTTON GROWER “Both 1997 and 1998 fiscal results were impacted by extremely harsh winter patterns that flooded over 41,000 acres of the Company’s Corcoran farming districts causing a decrease of $1,000 per acre or $41 million in gross revenues. Additionally, cold and wet spring weather delayed cotton planting by up to six-weeks which resulted in some of the worst farming conditions management has ever seen.” “Both 1997 and 1998 fiscal results were impacted by extremely harsh winter patterns that flooded over 41,000 acres of the Company’s Corcoran farming districts causing a decrease of $1,000 per acre or $41 million in gross revenues. Additionally, cold and wet spring weather delayed cotton planting by up to six-weeks which resulted in some of the worst farming conditions management has ever seen.”

5. CEMEX - #3 CEMENT MAKER WORLDWIDE “Weather was an important factor affecting cement demand, with unusually high precipitation levels in August and September, when compared to the same months of 2002.” “Weather was an important factor affecting cement demand, with unusually high precipitation levels in August and September, when compared to the same months of 2002.”

6. REDDY ICE – LARGEST US ICE MANUFACTURER “Cool or rainy weather can decrease sales, while extremely hot weather may increase our expenses, each resulting in a negative impact on our operating results and cash flow.” “Cool or rainy weather can decrease sales, while extremely hot weather may increase our expenses, each resulting in a negative impact on our operating results and cash flow.”

7. HYDRO QUEBEC – HUGE NA GENERATOR “Major variation in runoff is Hydro-Québec’s greatest risk, since 93% or our electricity is generated from hydropower …Significant temperature variances have an appreciable impact on seasonal demand.” “Major variation in runoff is Hydro-Québec’s greatest risk, since 93% or our electricity is generated from hydropower …Significant temperature variances have an appreciable impact on seasonal demand.”

8. What is weather risk management? • What is the weather market? • Who is XL Weather & Energy? • Case Study I: Almost Heaven Gas Company • Case Study II: Dry Creek Hydro Electric • How do you manage a book of weather risk? • Your career • Q&A

9. Weather risk management Financial weather risk is the occurrence of an observable weather event or variability in a measurable weather index that causes losses either to property or profits for an individual, government or corporation. Weather risk management products – packaged as either (re)insurance or derivatives – are settled off of the same index that has been determined to cause losses and reduces weather risk through mitigating payouts.

10. Types of weather risk

11. Manageable weather risks Temperature Precipitation Snowfall Wind Speed Streamflow Sunshine hours Hail Soil Moisture Humidity Hurricane Tornados A weather index is generally constructed as a function of frequency of occurrence and magnitude of event.

12. Current weather market index complex Risks Temperature (F/C): Minimum, Maximum or Average Precipitation: Rainfall and Snowfall Combinations: Dual Trigger Products Measurement and Indices Critical Day: Specific daily criteria – above or below (ie “Peak Days”) Aggregate: Accumulation of events over defined period (ie Seasonal Precipitation) Average: Mean outcome of events over defined period (ie Avg Temperature) Key is acceptable historical data and ongoing measurement

13. Non-catastrophic weather risk impacts volume PRICE x VOLUME = REVENUE PRICE RISK MANAGEMENT WEATHER RISK MANAGEMENT LOWER EARNINGS VOLATILITY +

14. Less volatility equals greater value Historical Revenues UNHEDGED Expected Revenues Without Weather Protection$75 Million HEDGED Expected Revenues With Weather Protection$73 Million Reducing the volatility due to weather has a budget cost but increases returns per unit of risk and can potentially improve stock valuations and the cost of/access to financing.

15. Who buys weather risk management products? • AgricultureCrop yield, handling, storage, pests • ConstructionDelays, incentive/disincentive clauses • EnergyReduced and/or excessive demand • EntertainmentPostponements, reduced attendance • GovernmentsBudget overruns • InsuranceIncreased claims, premium diversification • ManufacturingReduced demand, increased raw material costs • OffshoreStorm frequency/severity • RetailingReduced demand of weather-sensitive products • TransportationBudget overruns, delays

16. What is weather risk management? • What is the weather market? • Who is XL Weather & Energy? • Case Study I: Almost Heaven Gas Company • Case Study II: Dry Creek Hydro Electric • How do you manage a book of weather risk? • Your career • Q&A

17. €750mm Frost DaysConstruction A$25mm rainfall (hydro) Sep 2002 First weather trades 1997 First market maker on CME Feb 2002 CME weather contracts openSept 1999 CME offers a total of 20 Urban Temperature Indices 1997 1999 2001 2003 First meeting of WRMA 1999 First weather risk bond issued November 1999 USD$30mm Syndicated Winter Basket Issue £40mm temp (utility) 2002 International trading begins Element Re founded April 2000 Element Re renamed XL Weather & Energy February 2003 In 2004, 122,000 weather risk management contracts have traded on the Chicago Mercantile Exchange, with 70,000 thus far in 2005. Evolution of the weather market

18. End Users Intermediaries Primary Secondary Tertiary Generators Insurance brokers Banks Inter-dealer brokers Consultants Investors Insurers & Banks Energy Distributors OTC CME Construction Agriculture Energy Companies Reinsurers Retail et al Weather market landscape – 2005

19. Major market participants • ABN Amro (London) • Centrica (London) • Coriolis Asset Management (London) • Credit Suisse First Boston (New York) • DE Shaw (Kansas City) • Deutsche Bank (London) • Goldman Sachs (NYC) • Guaranteed Weather (Kansas City) • Merrill Lynch Commodities (Houston) • Ritchie Capital (Chicago) • Swiss Re (NYC) • TXU (Dallas) • XL Weather & Energy (Stamford)

20. World weather markets Active & growing Newly opening

21. PWC WRMA survey – 2003 results

22. What is weather risk management? • What is the weather market? • Who is XL Weather & Energy? • Case Study I: Almost Heaven Gas Company • Case Study II: Dry Creek Hydro Electric • How do you manage a book of weather risk? • Your career • Q&A

23. XL Weather & Energy XL Weather and Energy (XLWE) is the preeminent global weather risk management solutions provider, offering insurance, reinsurance and financial instruments. XLWE and its parent company - XL Capital - are dedicated to the long-term growth and development of weather risk management applications. • Established leader in weather market • Founded as Element Re by weather industry pioneers • Leader in market share and product development • Offices in Stamford, Kansas City, London, and Bermuda (20+ staff total) • Financial strength and network of XL Capital • Wholly owned subsidiary of XL Capital (Bermuda), within the Financial Products & Services division • XLWE is agent for XL Trading Partners, majority-owned affiliate of XL Insurance (Bermuda) Ltd. XL voted #1 dealer in weather swaps for 2003 by RISK magazine

24. XLWE within XL Capital XL Capital Reinsurance Financial Insurance Potential counterparties that offer weather risk protection include: • XL Weather & Energy Ltd • XL Trading Partners • XLWE business unit resides in this division • Indian Harbor • XL Insurance of NY • XL Specialty • (Admitted and E&S)

25. Liabilities $33.8B Assets $40.8B Equity $7.0B XL Capital International insurance, reinsurance, and financial products operations • Publicly traded since 1991 as XL on the NYSE Financial resources and stability recognized by rating agencies • Standard & Poor’s financial strength rating of AA- • Best’s claims-paying rating of A+ Market Capitalization of $10.6B as of February 2005

26. What is weather risk management? • What is the weather market? • Who is XL Weather & Energy? • Case Study I: Almost Heaven Gas Company • Case Study II: Dry Creek Hydro Electric • How do you manage a book of weather risk? • Your career • Q&A

27. Almost Heaven…West Virginia BACKGROUND The Almost Heaven Gas Company sells propane to residences throughout West Virginia. Recently, it has come under fire from the analyst community due to the severe annual earnings volatility it has experienced due to variable weather. CHALLENGE Within the next year, it must refinance the majority of its outstanding debt. With the increased scrutiny that Almost Heaven has been under, the CFO is concerned that the future cost of debt could greatly reduce the earnings potential of the company. SOLUTION The CFO feels there could be significant savings in the cost of debt if Almost Heaven were to eliminate its weather-driven earnings volatility. He undertakes to implement a weather risk management program before the upcoming winter to demonstrate to the analyst community that Almost Heaven has proactively taken steps to improve the quality of its earnings.

28. 1 - Identify significant business exposure(s) to weather 2 - Quantify the impact of adverse weather on business 4 - Execute contract in optimal form to address business concerns 3 - Structure a contract that pays when adverse weather events occur premium Coverage Layer AH XL coverage The four steps to hedge design

29. Identify exposure – what is the hedging index? Weighted Heating Degree Days (WHDDs) • Proxy for propane demand over heating season • Like demand, cannot be negative • Can construct a weighted index with individual components • Ex 50% Charlestown/50% Morgantown • Set baseline temperature TB and daily condition • Average temperature < 65o • Measure daily HDDs • If Tavg < 65o, then daily HDD = 65o - Tavg • If Tavg > 65o, then daily HDD = 0 • Aggregate over season • Simply sum daily HDDs

30. Weighted heating degree day example

31. Quantify impact – what is the hedge notional? HISTORICAL HDDS AND PROPANE SALES Year WHDD Gallons 2003 3219 44,800,000 2002 3978 56,400,000 • Identify best historical year • Identify worst historical year • Divide difference by difference in HDDs • Apply margin per gallon • Product is hedge notional (tick) 2001 3934 55,700,000 2000 3376 47,500,000 1999 3360 50,400,000 1998 3685 49,700,000 1997 3965 55,600,000 1996 2766 44,100,000 1995 3347 45,900,000 1994 3257 44,233,987 Correlation = 92% BEST YEAR/WORST YEAR APPROACH 2002 had 3978 HDDs 1996 had 2766 HDDs 12,300,000/1212 =~10,000 Gallons/HDD $1/Gallon $10,000/HDD (GALLONS / HDD) x ($ / GALLON) = $ / HDD

32. Structural alternatives • Wing It • Exposed to both downside pain and upside gain • No hedge cost; just cost of not hedging • HDD Put • Protect downside/enjoy upside • Up-front premium • No credit necessary • HDD Swap/Collar • Protect downside/limit upside • No/low premium • Must be creditworthy

33. NORMAL Margin unhedged SLOPE = $MARGIN/HDD

34. RETENTION NORMAL Margin hedged with put PUT HEDGED

35. COLLAR HEDGED HEDGED COLLAR NORMAL - STRIKE + STRIKE Margin hedged with collar

36. Building a termsheet 1. IDENTIFY Location: In what cities or markets is AHGC at risk to the weather? What are the weightings of each city’s contribution to total sales / margin if the decision is to create a basket? Statewide, but best represented by Charlestown and Morgantown Index: What weather measurement is the most accurate proxy for the exposure? Average, minimum, maximum, event or cumulative? What is the basket weighting? Seasonal WHDDs (650F) = 50% Charleston + 50% Morgantown Period: What is the critical risk period for AHGC? Seasonal, annual, or multi-year?  November 1st through March 31st 2. QUANTIFY Notional: What is AHGC’s weather exposure per unit of the above index? This usually corresponds to margin/revenue lost per unit. $10,000 per WHDD Limit: What is the total amount of protection that AHGC requires per business period above? $4,000,000

37. Building a termsheet (continued) 3. STRUCTURE Type: Is the protection required an index guarantee (ie put/call) or an index exchange (swap/collar)? Put (Index Guarantee) Retention: This is the index level where the weather protection “attaches” -- should be set as a function of the amount of weather risk that AHGC wishes to retain, and is a key part of pricing. 300 WHDDs = $3,000,000 Pricing: Premium payable to XL for the coverage provided as well as payment terms (upfront, periodic, arrears, etc) is a function of Expected Value + Risk Margin. $1,500,000 4. EXECUTE Re/Insurance or Derivative: Depends on company structure, location of exposure on financial statements, tax, use of captive insurer, desired location of recovery, and many other issues. Insurance Once the solution has been structured and priced to AHGC requirements, XLWE would obtain an order on behalf of AHGC to bind coverage with the appropriate XL Capital entity.

38. What is weather risk management? • What is the weather market? • Who is XL Weather & Energy? • Case Study I: Almost Heaven Gas Company • Case Study II: Dry Creek Hydro Electric • How do you manage a book of weather risk? • Your career • Q&A

39. Dry Creek Hydro Electric BACKGROUND Dry Creek Hydro Electric generates electricity from its dam on the American River, south of Sacramento CA. The private equity firm that owns Dry Creek – Hydro Partners – plans to IPO the company within the next 12 months and wants to stabilize as much as possible the company’s cashflows. CHALLENGE Dry Creek has sold its entire 100MW capacity forward for the next five years via a fixed-price power price agreement with the Modesto Municipal Utility District (MMUD). While it has achieved price certainty on its expected generation, it must ensure that it has enough water to deliver on its commitment or face the prospect of purchasing expensive replacement power in the secondary market. SOLUTION Hydro Partners decides to pursue a five year “generation hedge” in the form of low precipitation cover indexed at Sacramento, its main watershed. It feels that the earnings stability this hedge provides should create high-quality returns that will attract investors to Dry Creek’s upcoming IPO.

40. Coverage Structure Weather Event Triggers Impact Index…Notional…Structure The structuring model reflects three sets of variables: Definition of poor weather Seasonal accumulation of water-equivalent precipitation in the key watershed Effects of poor weather Given shortfall in precipitation, % drop-off in revenue or increase in costs: • Less generation • Replacement power at wholesale cost Effects of protection Risk retained and limit of risk transferred, across all exposures • Premium costs • Historical effectiveness Create an intuitive hedge – express inches of precipitation as potential MW of generation and apply a dollar value.

41. high mark 2004 2007 2008 base 2005 2006 low mark Shaping a hydro hedge over time Structuring Inputs: • Precipitation thresholds (weighted by location/timing) • Positive if over base, negative if under base • Notional amounts (revenue gained/lost) per inch of precipitation • Financial deductible amount (cumulative for year/period) • Total gain / loss must exceed deductible to trigger payment (in either direction) • Settlement can occur monthly, quarterly, annually, or over term • Increased certainty of cash flows over time • Lower financing costs/improved budget visibility

42. Executable structure - precipitation collar Hedge Objective: Eliminate exposure to shortfall in precipitation at key watershed Index (inches) 77” Upside Pledged $12MM 61” Dead Band, No Payouts 55” Mean 42” Downside Covered $12MM 26”

43. What is weather risk management? • What is the weather market? • Who is XL Weather & Energy? • Case Study I: Almost Heaven Gas Company • Case Study II: Dry Creek Hydro Electric • How do you manage a book of weather risk? • Your career • Q&A

44. Start small… OPTIMAL HEDGE POSITION NEW CUSTOMER POSITION

45. …but get big and diverse fast! NEW CUSTOMER POSITION OPTIMAL HEDGE POSITION A high-quality portfolio attracts high-quality risks like a global magnet and consistently delivers dollars.

46. What is weather risk management? • What is the weather market? • Who is XL Weather & Energy? • Case Study I: Almost Heaven Gas Company • Case Study II: Dry Creek Hydro Electric • How do you manage a book of weather risk? • Your career • Q&A

47. Risk management is a state-of-the-art career… CAPITAL DERIVATIVE INSURANCE To be successful in today’s market, a practitioner must have a thorough understanding of each of these converging markets.

48. …but why consider it? It’s intellectually interesting work and can be very creative You’ll make jokes about options and you’re mother will never understand what you do all day It’s a truly global business that will enable you to live and do business all over the world You’ll spend a lot of time in airports with your phone glued to your head and miss a lot of the sights (“I hear there’s a big tower here in Paris.”) You will make more money than most of your childhood friends (unless you went to high school with LeBron James) You’ll work long hours and soon realize that free time is not for sale Risk management is growing increasingly important to every business and you should be able to have a long career Businesses can act very strangely where derivatives are concerned and you must engender the trust of your employer (ie no sleight-of-hand)

49. Different front office roles BUSINESS HEAD ORIGINATION PORTMGMT STRUCTURING RESEARCH

50. Wisdom from down the road • Differentiate yourself from the pack • Never go to an interview for a job you want without a leave-behind that shows your interest and creative thinking • Always be conscious of what your CV is going to look like in a year • Actively manage your career by choosing good roles • The early money is often not the best money • Be conscious of your shelf-life and build an experience base that is portable and won’t allow you to fall too far • Learn to spot the trends in your organization • A good weatherman watches the prevailing winds • Repay career kindness by one day helping someone else who is where you were • If it seems to good to be true, it probably is.