Lukewarm on weather derivatives

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Nina Röhrbein reports on whether investors are turning to weather derivatives as a means of assuaging climate change concerns

With freak weather conditions happening more and more often, and businesses bearing the brunt of these, irregular weather patterns are increasingly in the spotlight.

But are weather derivatives - which protect industries such as energy, agriculture, food and beverage, construction, tourism and leisure from the financial impact of day-to-day, or seasonal, fluctuations in the weather - of interest to institutional investors concerned about climate change?

Weather derivatives belong to the family of insurance linked securities (ILS). They are used to protect against non-catastrophic weather events such as heatwaves or extreme cold, which are more frequent but less damaging. This contrasts with catastrophe bonds, which deal with severe but infrequent events such as earthquakes or hurricanes.

"There is a bit more volatility involved in weather derivatives because of the relative frequency of the types of weather events covered," says Ryan Bisch, senior associate at Mercer in Australia. "In contrast, catastrophe bonds cover events that have a very low probability of taking place and do not carry the same volatility. However, weather derivatives have the same inherent risk premium, which differentiates them from buying stocks or bonds. The risk premium is not correlated to the traditional economy, as the risk is linked to natural weather events."

Transaction sizes vary widely in accordance with the risk parameters of the buyers, from thousands of dollars for small and medium-sized commercial and industrial buyers to $10-30m (€7.3-21.8m) sizes for larger enterprises, according to the Weather Risk Management Association (WRMA). The largest transaction in the market is syndicated and has an annual limit well in excess of $100m, says the WRMA. However, the average size of trades is between $1-2m, according to UK-based investment manager Coriolis Capital.

Bisch admits that while weather derivatives are beginning to pique the interest of some of their institutional clients, they are a new asset class and largely a niche play. "We have a number of institutional clients who have invested in ILS including catastrophe bonds and other reinsurance exposures, who are now undertaking additional work on weather derivatives," he says.

But while climate is the driver behind weather derivatives, concerns about climate change are of a secondary nature only. "One of the fallouts of the global financial crisis was the realisation that many of the more traditional alternative asset classes failed to provide adequate portfolio diversification. Hence, investors are investigating the use of weather derivatives to get exposure to real alternative risk premiums," says Bisch. "Climate change adaptation is currently looked at as potential but is something which we believe will get explored further over time."

According to Steve Brosnan, commercial director and head of risk at Cumulus Funds at PCE Investors Limited, the only real downside of weather derivatives is that the market is quite small relative to other financial markets. "But since weather derivative payments are calculated using physical variables - such as independent weather data - the market is not impacted by panic or sentiment so does not have the same fat tail risks seen in other markets," says Brosnan. "As corporates can no longer rely on easy access to financing, they are increasingly interested in hedging more of their risks, much like insurance."

According to Bisch, initial projections suggested the weather derivatives market could grow to as large as $200bn over time. However, it rose to around $45bn in 2006, falling to trades of only $15-20bn in 2009. "Some of the investment managers have indicated they have capital to invest in this space but are constrained by a lack of counterparties to do deals with. However, this market is expected to continue to grow over time."

The returns of weather derivatives can be comparable to catastrophe bonds. "However, the probability of loss is higher, therefore catastrophe bonds, which may generate returns of 7-10% with a probability of loss of around once every 100 years might offer a better entry point for acquiring insurance-related risk premia," says Bisch. For weather derivatives he pegs the returns at 8-14% for a portfolio with a high probability of loss. This is in line with the 11.54% return on 7.1% volatility generated by the Cumulus Fahrenheit fund in 2009.

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