Weather risk management

The market is capitalized for the big one; but then what?

By Michael J. Moody, MBA, ARM

The last few years have seen an increasing interest in weather and its effect on the world’s economies. In addition, there has been a correspond­ing increase in insurance and risk management products that are designed to reduce the adverse effects associated with weather.

It has been conservatively estimated that over 30% of all commercial enterprises are directly affected by weather, with many others indirectly affected. As a result, a specific branch of risk management—weather risk management—has been established to deal with the unique weather-related risks.

While a number of insurance products have been made available to deal with weather-related risks (e.g., flood insurance, hail insurance, etc.), the new approach for weather risk management has been via the alternative risk transfer (ART) market, which is designed to deal with the effects of loss of revenue, additional costs and shrinking margins that are caused by extremes in temperature, rain, snow, wind, etc. These newer ART products have begun to offer a new financing approach to this age-old problem. And for the most part, these new products had been meeting with increasing success. Then came the financial crisis of 2008.

The market today

In essence, there have been three primary insurance-linked securities directed at weather risk. The largest segment of this insurance-linked securities group is CAT bonds, followed by Industrial Loss Warranties (ILW), and Weather Derivatives. Over the past few years, these insurance-linked products have grown significantly. In 2007, for example, these products accounted for about 15% of the overall catastrophe property market and amounted to an estimated $200 billion of notional risk limits.

CAT bonds have grown significantly since their introduction; however, figures show a loss of forward motion over the past 18 months. Guy Carpenter, for example, notes that only six new CAT bonds were completed in the second quarter of 2009. This figure represents a reduction of more than 50% of risk principal and indicates just how quickly the hedge funds have abandoned this marketplace.

Like CAT bonds, ILW were also specifically developed to provide an alternative source of capital for the weather risk management market. Again, growth had been meaningful over the past three or four years; however, it dropped off sharply over the past 18 months and has gotten worse in 2009. Generally, ILW providers had been standing on the sidelines during the first half of 2009, believing that there would be significant potential coverage issues arising from the Florida property market. However, such was not the case, and currently there is a capacity glut in this segment, which has resulted in rates falling 15% to 20%.

Weather derivatives are still a new concept for many. The actual beginning of this ART market application occurred in the autumn of 1997, when several transactions between Koch Industries and Enron marked the start of the current weather risk management derivative market. Over 90% of this market is traded on the Chicago Mercantile Exchange. However, as with the two previously noted approaches, 2008-09 was an off period. An industry trade group, The Weather Risk Management Association, has indicated that the number of contracts traded fell to 601,000 in the period from April 1, 2008, to March 2009, from a high of 985,000 in the same period a year earlier, a drop of nearly 39%. In the same period, the notional value of the contracts fell to $15 billion, down from $32 billion, a 53% drop.

Recent developments

The past five to six years have seen much innovation within the weather risk management market as well as broader acceptance from market participants. For the most part, the insurance industry has been flush with cash over the past three or four years (prior to 2008) and, as a result, has been able to introduce a number of new products for the weather risk marketplace. Industry experts have been working on standardizing the new products, developing responsive coverage triggering methods, and innovative product designs. Products such as sidecars were introduced and integrated into the weather risk market. Based on the past work, it is expected that once the financial market becomes more settled, further product development and expansion will take place.

One of the trends over the past two years has been cross-trading weather and commodities by adding a new element to weather trading. Weather derivative traders noticed that the two markets often complement and supplement each other in several ways. A simple example of this would be where a weather derivative risk taker may want to develop an ART product for a low precipitation product such as drought. An easy way to manage this risk is to purchase a “call” on wheat, given that drought typically results in lower-than-expected supply of wheat, frequently driving prices up. There are a number of other ways where weather risk management can be used to combine weather risk ART products with commodity derivatives on a bundled basis.

By its nature, insurance is a capital-intensive business, and the recent financial market meltdown has left the insurance industry in a precarious position. While most experts agree that the industry could survive another catastrophe loss, the real problem would be how to reload capital should this occur. Many funding sources migrated to the insurance market following recent manmade and natural disasters. Whether that would be the case again is subject to much debate, so the industry is looking for more stable sources of capital. Previously, most insurance professionals believed that by converging with the capital markets, a permanent source of capital could be found. However, time has proven just how incorrect that assumption was. Going forward, this will be one of the greatest challenges for the insurance industry.

The 800-pound gorilla

For all of its advances over the last 10 years, weather risk management has yet to tackle the 800-pound gorilla in its market—climate change, aka global warming. Make no mistake; the insurance industry has been leading the fight with regard to the “greening” of the environment. Traditional insurers/reinsurers have been out front of this movement by introducing a plethora of new products and services specifically designed to insure “green” issues. These new issues include everything from auto coverage for new, fuel-efficient vehicles to property insurance for today’s greener construction techniques.

Insurers have not, however, tackled the full catastrophic potential that may be associated with climate change. Clearly, climate change will be a major game changer for the insurance industry, along with most other industries. We have only to look at the 2005 hurricane season and the financial effects from the three sisters (Katrina, Rita and Wilma) to see the potential of the adverse weather. And while the industry did survive the financial impact of these storms, it was due in large part to an excess capacity within the insurance industry. And this is where the rub comes in. Although most industry experts agree that despite the current problems within the financial sector, the insurance industry could survive a similar event, if it occurred today, it’s not the initial losses that would cause the problems; rather, it’s the reloading of capital following the losses of this magnitude that would create the problems.

Climate change has been on the radar since the mid-1980s, but it is only recently that it has finally received the attention it requires. It has always been a long-term problem that most people have been aware of and, for the most part, it has gotten the “kick the can down the road” treatment. Insurers are now becoming aware of the severity of the problem. For example, in 2008, Ernst & Young surveyed more than 70 insurance experts from around the world to determine the Top 10 risks facing the insurance industry. Climate change was rated #1, and for the most part, the other nine risks were either directly or indirectly related to or compounded by climate change.

The past few years have seen significant progress by international insurers and reinsurers in developing ways to mitigate the effects of greenhouse gas emissions and other climate changers. However, they need to put the same effort into determining a long-term strategy for dealing with the financial effects of climate change. The insurance industry runs on capital, and in today’s financial environment, capital is a scarce resource. Obviously, this stands in stark contrast to the environment just a couple of years ago. Until the industry resolves this critical financial issue, climate change will remain the 800-pound gorilla in the room.

Conclusion

Weather risk management, which provides the means of transferring the risk of adverse weather conditions to another party (typically the insurance industry), has experienced significant growth over the past 10 or 15 years but now has gotten bogged down by the current financial service sector meltdown. Prior to the meltdown’s “speed bump,” the industry was making real progress; and as many insurance industry observers agree, that progress will again return as the financial markets resolve their problems.

However, while climate change represents a major opportunity for the insurance industry, it could easily put the insurance industry out of business as well. Until the industry can identify a solution to its long-term problems with regard to sufficient capital, climate change will continue to be the industry’s Achilles Heel.

For additional information on weather risk management and climate-related concerns, go to www.greeninsurancesite.com.