The Risk Forecast
Insurers have the bills to prove that damages from weather-related natural catastrophes are rising rapidly. But weather does not have to be extreme in order to have a negative impact on cash flow—sometimes it is merely enough for it to be uncommon, unseasonal or even unexpected.
Volatile weather activity is on the rise, as is awareness of its impact on business performance. Deviations from expected weather can challenge any company’s revenues, expenses 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 any combination of these factors.
As more companies turn to this market in search of solutions for weather-related business risks, it is responding with increasingly innovative products worldwide. Despite growing awareness of the problems weather risk management addresses, however, many business professionals do not understand the sector. As a result, a number of organizations are unaware of the safeguards available and the opportunities to be derived from changes to expected weather.
Weather risk management is the supervision of financial risks that are directly or indirectly linked to the occurrence of an observable weather event or variability in a measurable weather index. Coverages are based around the accurate recording of independent weather data, which is then utilized in a tailored index matching a company’s revenue sensitivity. Without this, there can be no transaction. Availability and access to weather data have improved dramatically over the past decade, strengthening the argument for strategic weather risk management and enabling coverages to be structured even in remote locations around the globe.
The skill in weather risk management is to identify or construct the right index in such a way that it accurately represents the client’s business.
Weather Risk Rising
Insurers have the bills to prove that damages from weather-related natural catastrophes are rising rapidly. Between 1980 and 1989, the industry paid out $15 billion per year for weather damage. Between 2010 and 2013 alone, this reached $70 billion a year, Allianz reported.
But weather does not have to be extreme in order to have a negative impact on cash flow. Sometimes it is merely enough for it to be uncommon, unseasonal or even unexpected. For many businesses, small changes in temperature, rainfall, sunshine, snowfall or wind levels can mean a large change in income.
Weather impacts all commercial activities, with 70% of companies exposed to severe weather risk. Weather-related delays cost trucking companies in the United States up to $3.5 billion a year. Weather is also the cause of approximately 70% of the delays in the U.S. National Airspace System, costing at least $3 billion, according to the Federal Aviation Administration.
Based on 2012 figures from the World Bank, the National Center for Atmospheric Research (NCAR), the National Science Foundation (NSF) and Allianz Global Corporate and Specialty, an estimated 30% of the U.S. GDP—$5.7 trillion of the $15.7 trillion total—is sensitive to the weather. The impact of routine weather variance on the economy is as much as 3.4% of U.S. GDP or $534 billion, NCAR and NSF report. This sum does not include additional costs associated with extreme weather events, such as hurricanes or tornadoes.
Impact of Weather Variances on Businesses
Sectors such as energy, retail, food, clothing, tourism, distribution, transport and construction are just as sensitive to minor changes in the weather as they are to changes in interest and foreign exchange rates.
Energy companies are particularly vulnerable to variations in temperature and, as countries begin the switch from fossil fuels or nuclear to renewable sources, the sector is currently undergoing significant change. Germany’s recent decision to abandon nuclear energy and move over to generating 30% of its power from alternative energy sources, such as wind farms, by 2020 means its economy could be vulnerable to a lack of wind or sun hours, despite feed-in tariffs. And it is not only a lack of wind that can cause problems for turbines. Excess wind—particularly during the construction phase of offshore wind farms—can trigger delays in start-up and downtime in the construction program.
Both good and bad weather have the potential to keep people away from retail stores, posing demand and operational risks. Sales of many specific products are also highly sensitive to the weather.
A sunny summer could mean people go to the beach rather than shop, for example, impacting companies that sell the majority of their goods during this period. Meanwhile, inclement weather on Black Friday or during other major sales events can present a serious risk to retailers by preventing shopping during this critical retail sales season.
In the construction industry, variances in weather leave companies vulnerable to operational risk as freezing temperatures and frost can incur significant project delays and spiraling costs. Food and beverage providers may find their sales either increasing or declining depending on temperature extremes, while a lack of sun will almost certainly dent the business of holiday companies and tour operators.
The Forecast for Risk Managers
Deviations from expected weather are no longer an excuse for lackluster financial performance, however. While companies cannot control the weather, they are now expected to better mitigate the risk of its financial impact. Unlike with traditional insurance products, no physical damage is required for an insured to collect payment from weather risk coverages. Such products focus on the use of weather data—measurable variables such as temperature, precipitation, sunshine, snowfall and wind—as the basis for risk indices. Protection is based around the accurate recording of independent data.
Coverage is available for single and multiple weather perils and is moving into new areas ranging from protecting the crops of farmers across Africa from drought, to jewelry stores seeing a drop in customers due to inclement weather. The process of determining a loss is objective and, unlike with traditional insurance, settlement can be reached within a few days. Payouts can be made quickly, while the lack of revenue is still an active issue.
Nevertheless, many businesses, municipalities and governments are still not doing enough to identify the link between variations in climatic conditions and their own revenue streams, or to protect themselves against the considerable risks such scenarios present.
Although many companies are comfortable hedging a number of different risks and are increasingly focused on operational, legal and regulatory challenges, they neglect weather risk, which can be the main contributor to profit volatility. Companies that proactively manage weather risks benefit from lower financing costs and better budgeting and planning. They may even use it as a sales tool in terms of shareholder management.
There are a number of different areas in which risk managers who take weather risks seriously can reap benefits. These include helping to deliver improved returns—therefore bolstering equity valuations and revenue certainty—ultimately ensuring forecast reliability. Improvements in financing can lower the cost of capital, while protecting revenues from weather fluctuations helps ensure liquidity.
The first line of defense might be the desire to protect against too much rain or excess temperatures. However, this can be expensive, if historical weather measurements indicate a high probability of such weather events occurring. Alternatively, companies can give up partial upside in order to reduce the price of the weather coverage. This structure, sometimes referred to as a “collar,” reduces volatility risk and requires less upfront payment than a pure downside policy.
Weather risk management protection is especially critical in the alternative energy sector, where there is a considerable use of debt and some lenders require resource protection before granting funding. A wind farm that generates more power than anticipated due to steady, strong wind could give up some of its higher returns to help smooth earnings during periods when the wind fails to blow. Instead of just having a “put” option against a lack of wind, a “collar” structure is created for excess wind. If 100 points is the 30-year average of wind speed on the index and the wind registers over 110 points, the insured would pay the excess. If it is less than 90 points, however, a payout would be received. There would be limited, or even no, upfront premium necessary.
Weather risk management products continue to evolve, offering a variety of tailored solutions to sector-specific issues. In the Netherlands, for example, labor agreements prevent construction workers from working in freezing temperatures. If temperatures fall below freezing, construction workers are sent home with pay. If the freezing weather is extensive, the cost of wages and lost production can be extremely detrimental to a company’s income statement.
“Frost Day” coverages are another solution to offset the impact of cold weather on revenues. With this cost-control solution, purchasers receive an automatic payout if a predefined parameter for the number of frost days is met. By using “Frost Day” coverages, a construction company can minimize its financial risks. Over a number of years, Dutch companies have taken out several million euros in coverage to prevent losses from severe, sustained cold weather, thereby protecting profits from adverse weather effects.
New solutions mean there is now an upside to weather risk as well, including the possibility to use it as a promotional tool to boost sales. Weather promotions can be used as a creative marketing weapon to drive sales of anything from snowmobiles to sandwiches. The “sunshine guarantee” for convertibles may help a consumer protect against a lack of sunny days to enjoy having the roof down. For example, they may receive $100 as compensation for every rainy day after a defined threshold. Payouts are triggered using data from a local weather station in the state where the car is registered. The car company might subsidize the cost of the coverage in full or in part, or the coverage might be offered to the customer as an option.
Preparing for a Rainy Day
With volatility increasing, weather will continue to be viewed as a core risk to business performance. Weather risk management tools are becoming a powerful weapon in the risk manager’s armory, helping to combat growing shareholder concern about the impact even minor changes in weather patterns can pose to returns. Demand for these products is expected to grow significantly in the future across a number of different business sectors and geographical territories.