Weather risk management on the rise in China
1. More and more corporates and individuals take up weather solutions
Aquaculture insurance has always been a conundrum due to its complexity in risk assessment and claim handling. Recently, Swiss Re partnered with China Pacific Insurance and launched a temperature index insurance product for the hairy crabs. This product compensates the hairy crab farmers for the loss of output due to persistent high temperature, measured by the weather data provided by meteorological stations. This marks the first time of the aquaculture industry adopting temperature index insurance in China.
In the Taihu region in Jiangsu province, there are about 3,000 hairy crab farms, with a total enclosed breeding area of approximately 3,000 hectare. The cost and output value of hairy crab farming in normal years are around RMB 75,000 and RMB 150,000 per hectare respectively. High temperature represents one of the major threats to hairy crab farming. The consecutive high temperature days during the summer of 2010 and 2013 caused severe losses for the farmers. The farmers had to absorb all the losses themselves in the absence of insurance. The temperature index insurance product provides a solution for the farmers to mitigate such weather risks with an easily understandable structure, and a fair and objective payout mechanism. The product was well received by the farmers as well as the local government, who promised to provide certain premium subsidy for the local farmers.
Swiss Re is the leader in the global weather insurance market and has started to promote weather index solutions in China over the past few years. This high-temperature insurance product represents only one of the various weather solutions Swiss Re jointly developed with its domestic partner insurers. In May this year, Swiss Re, together with Alltrust and ZhongAn insurance respectively, developed some temperature index insurance products for corporates and individuals. These products were sold both through both online and offline sales channels, and turned out to be a great success. As early as 2011, Swiss Re partnered with Dinghe Property Insurance and pioneered the first precipitation power generation index insurance solution for the SSE listed Guangdong Meiyan Hydropwer (later renamed as Guangdong Meiyan Jixiang). This marked the birth of drought risk solutions for hydropower companies in China. In 2013, Swiss Re collaborated with Alltrust Insurance and launched China’s first wind power index insurance product that compensates the policyholder, a domestic wind power generation company, for losses in power output due to shortage of wind resources.
While weather exposure is well known in various industries such as agriculture and energy, weather solutions are still new to this country. Weather risks have traditionally been perceived as force majeure and unmanageable. The emergence of weather solutions makes proactive weather risk management possible. With increasing knowledge on weather risk management, more and more companies and individuals have started to utilise weather solutions to limit their weather exposure to a bearable level.
2. Risk management or gambling?
As with many other new products, the emergence of weather solutions also encountered some challenges. For example, some people claimed that weather insurance is gambling.
The difference of insurance and gambling is whether there is exposure and thus insurable interest. Take high-temperature insurance products as an example: Shanghai’s neighbouring regions encountered persistent heat wave during the summer of 2013, which led to economic losses at a large number of aquaculture farms. According to Anhui Evening News, the economic losses suffered by the province’s fisheries industry due to high temperature and drought reached RMB740 million during July and August 2013. Hairy crab farmers at the Taihu region were also severely affected. Based on estimation of the Taihu Fisheries Administration Committee Office of Jiangsu Province, the overall output of enclosed crab farming in the region was down by 20-30% due to the heat wave; some farmers even suffered total loss. The heat wave also led to notable increases in personal expenditure such as electricity bills and costs for drinks, and in allowances paid by the employers. In all the provinces and municipalities in China, there are relevant regulations in place, stipulating high-temperature allowances payable (the amount varies between different regions though) by the employers during the summer season or the days with extreme high temperature, which is on top of the normal wage payments. Furthermore, some regulations require employers to pay additional compensation to their employees to cover the cooling costs in case of extremely hot weather. Such potential losses and additional expenditures represent the insurable interest and hence constitute the context and starting point in the design of high-temperature insurance products.
Extreme high temperature represents only one type of weather risks companies and individuals face. Drought, frost, wind and rainstorms could also cause big losses. For example, the widespread frost in southern China during 2008 not only severely hit the electricity grids, but also caused huge economic losses for aquaculture farmers; the drought in southwest China in 2011 led to significant losses for both the local agriculture industry and the hydropower companies; and the flood in northeast China in 2013 caused severe damages to the agriculture industry. Data on economic losses from these natural perils can be easily found from news reports. In the absence of weather solutions, companies and individuals have to assume these risks themselves, which could be very costly. Weather risks could directly lead to financial losses and cash flow difficulties. Some companies even had difficulties in paying its employees salary. As a result of weather risks, some companies suffered credit downgrading, and some listed companies were put on the warning list of Stop Trading (ST) by the stock exchanges, which undermines the financing capacity and the reputation of the company. These all represent exposure and insurable interest.
Therefore, weather risk management is different from gambling. In fact, if a company manager is aware of his weather exposure but takes no action against it and merely hopes for good fortune to prevail, he is actually gambling with the earnings of the company against the weather conditions.
3. Balancing premium and benefits
Temperature insurance products are different from other insurance products under the background of global warming. Based on the data over the past 50 years, we observed clear trend of rising temperature almost unexceptionally. This implies that the average temperature of a particular city over the past 50 years may have being 30 degrees Celsius, but it may reach 30.5 or even 31 degrees Celsius over the coming 50 years. The exposure on high temperature is increasing. The insurers have to take this factor into consideration from the underwriting perspective. The treatment of this factor many differ among insurers, but simply disregard of the global warming factor and merely relying on historical average readings is definitely inappropriate.
From the policyholders’ perspective, the value of insurance is not necessarily the compensation amount is higher than the insurance premium paid, but rather the much needed payout received during outbreak of weather perils. Policyholders may end up disappointed on most occasions should they possess a speculative mentality and wish to profit from insurance products. Needless to say, insurance companies need to survive with profit. On the other hand, the best outcome is no outbreak of risks if the intention of the policyholder lies in risk preparedness, because the actual loss suffered by the policyholder is quite likely higher than the payout. The policyholder should make decision between the following two scenarios: (1) being prepared and insured with relatively small amount of annual premium payments or, (2) remaining uninsured and exposed with the potential direct and indirect losses. Without weather solutions, the companies may face the following situations in case of adverse weather conditions: erosion of profit or even incurring losses, unable to achieve operating targets, tight cash flow which can sometimes threaten the company’s survival, higher financing costs due to downgrade in corporate credit rating, disruption to the implementation of long-term strategic plans including investments etc. Companies may have to pay high prices to get back on track after weather events. In contrast, by adopting weather solutions, the companies can mitigate the unforeseeable and non-controllable weather risks with foreseeable premium budget.
Besides payouts in case of adverse weather conditions, weather solutions could bring other added value for companies. For example, weather exposure represents one of the major risks for hydropower and wind power companies, which has to be disclosed in the risk disclaimers in corporate prospectus or credit rating reports. Without effective measures to mitigate such exposure it will undermine the corporate credit rating and investors' confidence. Appropriate weather solutions could address this issue and thus help the corporates gain access to favourable financing conditions or higher financing amount. In China the regulation stipulates that companies have to remain profitable for three consecutive years prior to their listing. Occurrences of adverse weather conditions may hence delay the progress of the company’s IPO, leading to significant financial losses. Such scenarios can be prevented by adopting appropriate weather solutions.
4. The emergence of weather risk management: an evolving trend
The public’s understanding on weather risks is changing: from something not manageable to how to manage such risks. Results from an earlier survey we conducted on domestic hydropower companies indicated that the majority of the senior executives were well aware of the weather exposures. However, only few of them knew that they could take proactive risk management such as weather solutions. We received similar feedbacks from other industries. Following the increasing awareness on weather solutions, the decision making of the senior executives will transit from whether weather risks can be managed to how such risks should be mitigated and with what solutions. In the meanwhile, the expectation on corporate governance will also change: weather risks were perceived as force majeure and the managers hence were not held accountable in the past when the public were not aware of weather solutions; in the future, however, the public will question whether the managers have made appropriate decisions on risk management and whether there would have been better solutions for weather risks.
Domestic corporates are currently evolving from an extensive management style to a delicacy and specialised management style. The latter calls for identifying the possible risks, analysing the probability and impact, and formulating corresponding solutions. Specialised risk management will also drive a shift of risk mentality from hoping for good fortune to prevail to risk preparedness, from one that relying on ad hoc risk financing after the outbreaks of weather risks to one that makes proactive funding arrangements in advance. Against such backdrop, more and more corporates will choose to transfer part of their weather risks to professional risk bearers, in order to reduce disruption to company operations and to concentrate the corporate resources on more strategically-important areas.
Published September 2014