Financial solutions for weather risks
Climate change is a fact: one of its effects is an increase in the volatility and unpredictability of weather events, for example maximum and minimum temperatures, the number of hot or cold days and precipitation levels. Human activity contributes to climate change, but it can also help mitigate its effects on weather events. The insurance industry, through its expertise in risk management, plays an important role in developing solutions to tackle the weather-related uncertainties.
This Business Case is part of Swiss Re's Annual Reporting 2005. For more information, please see the comprehensive Annual Reporting 2005 package.
The weather has never been predictable. 2005 – with its freezing March in Europe, record-breaking hot summer in the United States, and intense Atlantic hurricane season – shows how extreme its fluctuations can be. Variable weather affects supply and demand in almost every industry: evidently in such sectors as energy or agriculture; more subtly, but still significantly, in others, for example retail, clothing or entertainment. The US Department of Commerce estimates that, of America’s USD 11 trillion economy, USD 3 trillion is directly affected by weather. For many industries, it is the greatest risk to earnings: a risk that cannot be prevented, avoided or isolated.
As the weather becomes more volatile, society will require more powerful methods to manage its inherent risks. Swiss Re has, among other climate-related initiatives, been developing weather risk transfer products both in derivative and insurance form – instruments for transferring weather risks from affected companies to the capital and insurance markets. Companies with a clear understanding of how weather affects their business can buy these instruments to protect themselves against unusually warm, cold, wet or dry weather.
Knowledge is vital to using a weather derivative well: companies must make a rigorous analysis of how the weather affects their business. A farm, for instance, would need accurate data about the impact of variation in rainfall on the volume of grain it harvests. An energy company might study the correlation between summer temperatures and energy sales levels. Understanding the size of risk a company faces from the weather allows it to structure a derivative to transfer some of that risk to the financial markets.
In exchange for a premium, the typical weather derivative pays a specified sum when a certain weather measure, such as rainfall or temperature at a given weather station, exceeds an agreed level for an agreed time. This cash sum – paid when, for instance, there is drought during a farm’s growing season – offers partial compensation for the weather’s unpredictable behaviour. The size of the weather derivatives market has grown sharply, from nearly nothing in 1997 to USD 40 billion notional market value in 2005, as companies have become more aware of the risk that weather poses to their businesses and the weather itself has become more changeable. More than 5 000 contracts were traded in 2005 between 40 market participants, mainly in the US, Europe and Japan, with some strong interest coming from India and South America.
For the reinsurance industry, weather risk provides an extension to portfolios and a source of diversification. Reinsurers are able to offer expertise in managing and packaging large risks, as well as the capital to underwrite derivative issues, thus helping to mitigate the financial impact of the variability in the world’s climate.
“Weather risk derivatives give our clients a predictable way to manage unpredictability – and us an opportunity to diversify risk.”
Juerg Trueb, Head Specialties and Environmental & Commodity Markets, Globals & Large Risks Division
Reducing the impact of uncertain weather
For Swiss Re, weather derivatives represent more than simply an attractive growth market: they provide a practical method of advancing the corporate objective of sustainability. As well as structuring these products for companies in developed countries, Swiss Re works with global institutions, applying weather risk management techniques to solve problems faced by emerging countries.
In India, Swiss Re, direct insurance companies and banks jointly provide protection for Indian farmers against the risk of below-average monsoon rainfalls. Weather insurance policies, structured and priced by Swiss Re and distributed by local partners, have given thousands of Indian farmers an effective method for reducing the impact of uncertain weather on their livelihoods – just one way that Swiss Re’s expertise in risk management helps create sustainable solutions for global problems.
