Weather risk transfer

We develop bespoke solutions to manage weather risk impacting output, prices and revenue across a range of industries. Key to this process is working with equally innovative risk takers who understand our clients’ needs, take the time to develop a solution and price risk competitively and sustainably.

Derivatives are the main tool. There are a number of advantages to derivatives and these are often linked to what derivatives are not – indemnity-based insurance. Use of derivatives can also serve to emphasise what is most important to a client – the underlying or notional commodity, often representing their “product”.

These derivatives are often referred to as parametric or index products. Payouts or settlements are calculated in accordance with an agreed formula based on particular weather inputs. They are designed to replicate loss or damage without the need to prove the actual quantum.

Ultimately, regardless of the product, it is our approach to risk management and our experience and insights that set us apart.

Some industries have been quicker than others to respond to the risks of weather and to take advantage of derivatives and other financial products for risk allocation. However, we feel we can be of use to just about any large business affected by weather.

Misconceptions still persist. These can include:

• Businesses just have to accept losses associated with weather;
• Weather is unpredictable and nothing can be done about it;
• Businesses are on their own in dealing with weather;

We believe weather risk management can be a source of competitive advantage, allowing businesses to put resources to their best use and to focus on their core activities.

When it comes to weather, the businesses that we can assist broadly fall into three overlapping categories:

• Businesses inextricably bound up with weather (eg. energy and agriculture);
• Businesses that can be disrupted by adverse weather (eg. mining and transport);
• Businesses indirectly affected by weather, including those with customers whose demand for their products is driven by weather (eg. suppliers to the agricultural sector).

Potential applications of weather risk transfer include:

• weather on production and consumption of energy;
• storms on infrastructure;
• wind and rain on construction;
• rainfall and other weather events on growing seasons and harvests.

We elaborate on some of these applications below.

The means for transferring risk

Beyond acceptance of alternative risk transfer as a means of risk management, we now observe increased interest globally in investment in funds and other vehicles that supply the risk capital.

This goes further than catastrophe bonds and insurance-linked securities. New funds and providers are regularly springing up.

These developments also mean “traditional” risk carriers in this field (eg. reinsurers) are also getting more creative and are looking for new sources of capital.

An abundance of risk capital from more sources than before can only be a positive for clients. It is part of our role to know which risks suit which counterparties. We place great importance on our relationships with counterparties built over many years, in some cases 10 years and more.

The motivations for transferring risk

Another shift we see is a rejection by investors and communities of complacency when it comes to climate change and its attending risks.

They want to know more about how companies’ prospects are linked to, and dependent on, favourable climate and weather. Regulators are also moving with them and reports from the UK’s Financial Stability Board (and subsequent endorsement), the Australia Prudential Regulation Authority and other bodies suggest that public companies, and not just financial institutions, will be forced to make change.

We see disclosure as a first step. Soon we expect investors and communities will demand that their companies actually do something to reduce the risks identified.

Risk transfer will be key to this and directors and officers who ignore the opportunities leave themselves vulnerable to a growing number of agitators.

Energy / renewables

Energy production and the resulting returns can be uncertain and weather is often an important determinant. Weather pays a crucial part in both energy production and consumption.

We work with energy producers and retailers to address the need for certainty in output, prices and revenue. We are also increasing working with consumers of energy and those offering demand-side solutions.

Key areas include:

• Products for firming (hedging) production directly, particularly renewable energy sources such as wind and solar, and incorporating price risk protection;
• Products based on parametric structures with inputs for energy production or determinants of demand – eg. temperature, rainfall and wind speed;
• Products for mechanical failure of power generators – forced outage cover traditionally for coal and gas-fired power stations.

While this last category mainly relates to mechanical failure, understanding the impact of weather on output, demand and prices (particularly during an outage) is crucial to covering forced outages effectively.

Agriculture

Another area where weather directly affects output is in agriculture, particularly crops. Growing seasons and harvests hinge on favourable weather.

Instead of riding out bad seasons, derivatives can be used to offset low yields. Products based on parametric structures can provide fixed payouts where key weather inputs fail to meet agreed benchmarks. For instance, it might be a lack of rain or excess rain at the wrong time that triggers a payment.

Crucial to this form of risk transfer is understanding just how an unfavourable change in weather conditions can impact on production and revenue to determine in advance the monetary consequences.

Infrastructure

A major risk to the operation of infrastructure are storms and some areas of Australia are more susceptible to storms than others.

While some government and quasi-government bodies might have compensation schemes to rely upon, private operators must generally look for creative ways to manage the risks of storm interruption. Even government bodies are under increasing pressure to make better use of taxpayer funds, particularly where there are more suitable parties willing to assume the risk.

Products can include structures where a payment is made based on:

• the physical path of a storm; and
• using a more nuanced approach, with key weather readings across different data sources in different areas.

This type of application perhaps best illustrates the benefits of derivatives where there is no need to show and quantify actual loss. Products provide certainty of payment with a fixed maximum exposure and corresponding compensation. Settlements can promptly follow the event without the need for a physical loss to “crystallise”, which may not be apparent until much later.