The Role of Weather Risk Management
How the insurance industry can continue being leaders in climate change adaptation.
Swiss Re | November 9, 2009
Climate change mitigation has been at the forefront of several high profile debates. The European Union has created a cap and trade framework to address the goal of emission reduction and other nations such as the United States have experimented with regional emission reduction regulations. There are, however, also other areas where insurance companies and other financial institutions can contribute to the challenges of a changing climate: one of which is the area of climate adaptation.
Adapting to a changing climate can be done through a broad range of measures. With respect to insurance, weather risk transfer solutions can be used to address the increased volatility in the weather caused by climate change. According to an annual survey conducted by PricewaterhouseCoopers and commissioned by the Weather Risk Management Association, the notional value of the weather market grew from USD 2 billion in 2001 to around USD 20 billion in 2008. While this is still a small and niche industry, there is strong foundation and growing global demand for these products.
 Figure 1 Total Notional Value of Weather Contracts in millions of USD. Source: PwC
Opportunity knocks!
There are several different avenues for insurers and other risk takers to participate in the weather risk management sector. Potential clients can come from a broad range of industry segments including energy, agriculture, construction and transportation that utilize these products. Additionally, the public sector has an interest to increase its resilience against climate change through replacing ex-post disaster payments with ex-ante risk management strategies. Below we provide a series of examples highlighting the demand for weather risk solutions.
Energy
An example of a corporate client in the energy segment is a utility company that has exposure to warm winters, when they sell less heating oil or natural gas to their customers and as a result have lower earnings. This risk can be mitigated by analyzing the sensitivity of their sales to average temperatures and then purchasing protection against warmer than normal temperatures in the region of operation such that the utility receives a payout depending on the variation of average temperatures from normal or a pre-determined attachment level beyond a deductible layer. The cover can be further customized for utilities that have commodity price exposure in combination to their exposure to temperatures.
There has been a sharp increase in the range of weather risk management solutions that target the renewable energy sectors such as hydroelectric, wind, geothermal and solar generation. An example is a wind speed hedge that would protect a wind farm against reduced long term wind speeds, which is a major assumption in the economic viability of a new project. Banks, lenders as well as other investors that provide financing for these projects are subject to significant losses if there are large deviations from this assumption of long term wind speed. An issue that complicates the design of hedges for renewable energy projects is basis risk, which is the difference between the expected generation forecast by the weather index and the actual generation produced. While there are factors not related to weather which impacts generation and results in basis risk, a major reason for this is that there are generally no reliable weather stations at or near the site of the renewable energy project and the closest major station could be a significant distance away. This occurs as renewable projects tend to be at remote locations. There have been a few advances recently that involve using satellite data and/or installing new weather stations to address this issue.
Public sector
Insurers have worked with governments and non governmental agencies to provide disaster recovery funding from catastrophic weather. A recent example of this public private partnership is a transaction structured by the World Bank to protect the Government of Malawi against severe drought. During a drought, the output of maize produced in Malawi falls dramatically, resulting in reduced farmer incomes and can negatively affect the government budget. An analysis to understand and quantify the relationship between rainfall and maize production was conducted by the World Bank and a weather hedge was created such that the maximum payment is reached if the maize production dropped to 10% below the historical average. In order to price and transfer this risk to the private sector, the World Bank entered into an agreement with Swiss Re, who is the ultimate risk taker in the transaction. A major benefit of this type of ex-ante disaster management is that the payment is made automatically if the weather related index is triggered, without the need to file any claims or wait for funds from donors and aid agencies to start trickling in after the incident.
Small and medium sized companies
There have been a few web based weather risk management portals launched recently that allow small and medium sized enterprises to analyze their weather risk and then customize, price and purchase weather risk protection online. This has enabled tourism related companies to offer refunds to individual customers if the number of rain days during their trip/vacation exceeds a threshold. Similarly snowmobile manufacturers can offer refunds to their customers if there are is too little snow during the winter. There is wide applicability for these products on the retail level and it works well for any outdoor event, such a golf tournament or a local community fair, whose revenues can be negatively impacted by inclement weather.
Summary
The increased range of products that are currently offered to end users and competition among risk takers has led to greater price transparency, which has benefited organizations looking to offset their weather exposure. Additionally as a result of the current situation in the equity and debt markets, it is difficult and expensive for companies to raise new capital and thus the need to protect against unexpected weather and climate effects becomes all the more important. As the uncertainty in global climatic conditions increases and extreme weather events seem to occur more frequently, these products offer the opportunity for organizations to shield their fortunes from the vagaries of weather and focus on their core business. |
