Economic costs of weather volatility exceed impact of natural catastrophes

by Artemis on November 26, 2013

The annual economic costs from routine weather variance or weather volatility can far exceed the costs caused by natural catastrophes, according to a report showing the importance of weather risk management from insurer Allianz Global Corporate & Specialty SE.

Volatile weather is increasing around the globe, according to the report, as evidenced by recent events such as super typhoon Haiyan in the Philippines and the flooding from cyclone Cleopatra in Sardinia. These extreme events often grab the headlines but Allianz says that minor variations in the weather can have even bigger impacts on business performance across a range of industries, resulting in greater economic losses.

The report looks at the impact of weather variation on businesses and suggests ways that they can manage their weather risks more effectively. New approaches to weather risk management can help businesses hedge the impacts of weather variability on their bottom-line, smoothing earnings and providing value to their shareholders.

While the reinsurance industry spends much of its time focused on property catastrophe risks, the report suggests that weather risks have a much greater economic toll around the world. The economic impact of increasing everyday weather volatility far exceeds the costs of natural disasters on an annual basis, sometimes as much as three times greater.

Allianz estimates that routine weather variation in the European Union could cost as much as €406bn (£346 billion /$561bn) each year. Compare that to the natural catastrophe costs of 2012, when 905 natural catastrophes worldwide, 93% of which were weather-related disasters, cost around $170 billion.

The direct costs from weather volatility are rising, according to Allianz, with insured losses from extreme weather events globally costing $70 billion every year for the last three years alone. Back in the 1980s the insured loss toll from extreme weather was much lower at around $15 billion annually.

Karsten Berlage, Global Head of Weather Risk Management at Allianz Risk Transfer, said; “Deviations from expected weather can challenge any company’s revenues, costs or profits. The weather risk management market enables businesses to actively manage such financial risks based on the weather event or variability in question – be it temperature, rainfall, snow, wind or even a combination of such perils.”

The weather risk management market has been in existence for around 20 years, from its beginnings offering hedging for energy firms in the form of heating and cooling degree day swaps and derivatives. Awareness of the impacts of weather on business has grown but often the awareness of the available hedging and weather risk transfer tools is lacking, meaning the market has not really become as mainstream as it was thought it would.

The solutions offered by weather risk providers are becoming more sophisticated and growth is expected across a range of industries, from retail which is one of the worst affected by weather variability, to agriculture, alternative energy and leisure.

The report says that weather impacts all commercial activities with around 70% of companies exposed to severe weather risks. Estimates suggest that around 30% of US gross domestic product (GDP) is directly or indirectly affected by weather and climate ($5.7trn of $15.7trn). Routine weather variance is estimated to have an impact on the U.S. economy of as much as 3.4% of GDP, or $534 billion per year.

These numbers are enormous and show the potential size of a market in weather risk and therefore weather reinsurance and risk transfer structures. The tools available to re/insurance buyers; weather swaps, weather derivatives, weather-index products, weather guarantees and parametric covers, will all require reinsurance solutions to be created, an area where the alternative market and also third-party reinsurance capital can offer support.

Weather risk securitizations have been transacted in the past, using a catastrophe bond structure to transfer weather risks directly to the capital markets. As awareness of weather variability risks grows, insurance-linked securities are one risk transfer solution which could see more weather risks transferred to third-party investors.

There have been discussions in the past about using ILS and catastrophe bond structures as a way to help developing nations hedge climate and weather variability. The capital markets is the only source of capital able to absorb risk on this scale and discussions on these types of initiative are likely to continue and escalate as awareness of weather risk grows.

A number of specialist ILS managers already invest in weather risk instruments, including Nephila Capital and Coriolis Capital, both of which have invested in and provided capacity for weather risks for a number of years. Weather risk can provide an attractive yield with low correlation to broader financial markets, in the same way that catastrophe risk can. As a result we expect to see more third-party capital becoming interested in weather risks in the coming years.

For now though, the aim of this report from Allianz is to generate interest in protecting businesses against weather variability and volatility. Weather risk management solutions are now more available than ever and even more customisable than before, enabling them to be used by a wider range of businesses.

“However ‘bad’ the weather is, it is no longer a good excuse for disappointing earnings,” explained Karsten Berlage. “Stakeholders are increasingly aware of this. While companies cannot be expected to control the weather they are now expected to better control the risk of its financial impact. This can be achieved through weather risk management solutions.”

As weather risk management continues to gain traction this market will increasingly be one that institutional and capital markets investors can access, through ILS managers or other specialist investment funds. That will increase the amount of capacity available to underwrite weather risks which should help to bring down prices of some customised solutions, making them more accessible to a greater range of business owners.

Berlage said; “Weather will increasingly be viewed as a core risk to business performance. Therefore, demand for weather risk management solutions should grow significantly in the future with stakeholders able to reap the benefits of better cash flow stability, more accurate budget management, greater earnings consistency and higher risk-adjusted returns.”

You can access the full report from Allianz here.

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