Cedric Stephens | Non-traditional ‘insurance’ as disaster-recovery tool

The lead story in the Finance section of last Wednesday’s Gleaner, ‘Flow Expects US$44 million payout for Beryl’,’ grabbed my attention.

It was juxtaposed against another article: ‘Industry Estimates US$500 million hit for Regional Property Insurance from Beryl’. Even though these figures apply to the Caribbean region, they also reflect some of the impacts of climate change that we are experiencing locally.

The Minister of Finance and the Public Service’s $45 billion (US$290.3 million) damage estimate for Hurricane Beryl, the undisclosed restoration costs to electricity supplier’s transmission and distribution infrastructure, plus the unquantified uninsured losses in the wider economy, are evidence of the reality of climate change that the region continues to face.

‘Building resilience is not optional; it is an imperative for our survival,’ as Prime Minister Andrew Holness stated in June 2018 – even though it may seem like a Sisyphean struggle.

The parent company of telecommunications provider Flow parent and the regional insurance carriers handled Beryl’s hurricane risk in different ways. The global capital market handled Flow’s by way of a weather derivative which, locally, would be considered a non-traditional strategy. The regional insurance companies handled theirs in the global reinsurance centres. This is the traditional way.

Weather derivatives are sold in the capital markets. Reinsurance protection is sold in financial centres in Bermuda, the United States, Europe, and Asia.

What is a weather derivative? A weather derivative, according to Investopedia, “is a financial instrument used by companies or individuals to hedge against the risk of weather-related losses. The seller of the derivative agrees to bear the risk of disasters in return for the payment of a premium. If no disaster event occurs before the contract expiry, the seller will make a profit. In the event of unexpected or adverse weather, the buyer of the derivative instrument claims a pre-agreed amount.”

A derivative is a financial instrument whose value is tied to an underlying asset. The main types of derivatives are options, futures, forwards, and swaps.

Investors use a hedge to reduce the potential for loss in other investments. The price of a hedge tends to move in the opposite direction to the investment. This strategy works as a kind of insurance policy that offsets any steep losses in other investments.

Reinsurance is often described as the buying of insurance-by-insurance companies. It is a contract between a reinsurer and an insurer. In the contract, the insurer – known as the ceding party or cedant – transfers some of the risks its assumes from policyholders to the reinsurer. The reinsurance company then assumes all or part of those risks issued by the ceding party in exchange for part of the original premium paid by the policyholder. In the event of a loss, the reinsurer pays the pre-agreed portion of the loss to the cedant.

The profitability and revenues of most businesses – agriculture, energy, entertainment, construction, travel, and others – to some extent depend on the vagaries of temperature, rainfall, and storms. Unexpected weather rarely results in price adjustments that entirely make up for lost revenue, making weather derivatives securities that allow companies to hedge against the possibility of weather that might adversely affect their businesses an important investment.

Companies whose businesses depend on the weather, such as hydroelectric businesses or those that manage sporting events, might use weather derivatives as part of a risk-management strategy. Farmers, meanwhile, may use weather derivatives to hedge against a poor harvest caused by too much or too little rain, sudden temperature swings, or destructive winds.

The sellers of Flow’s derivative instruments will pay out the US$44 million – not insurance companies.

Weather derivatives are similar to but different from insurance. Insurance covers low-probability, catastrophic weather events such as hurricanes, earthquakes, and tornadoes. In contrast, derivatives cover higher-probability events such as a dryer-than-expected summer.

Insurance does not protect against the reduction of demand resulting from a slightly wetter summer than average, for example, whereas weather derivatives can do just that. Since weather derivatives and insurance cover two different possibilities, a company might have an interest in purchasing both.

Also, since the contract is index-based, buyers of weather derivatives do not need to demonstrate a loss. To collect insurance, on the other hand, the damage must be shown.

Elizabeth Riley, executive director of the Caribbean Disaster Emergency Management Agency, and others, wrote an article in this newspaper about resilience with the intriguing headline, ‘Hurricanes are Inevitable, But Disasters Are Not’.

The article concluded: The destruction caused by Hurricane Beryl will not be easily forgotten. Equally important, we must not forget that Hurricane Beryl proved once again the value of investing in disaster risk reduction as demonstrated by the success of early-warning systems in saving lives. However, more must be done, especially to prevent the loss of livelihoods and development gains. That is why we hope the experience of Hurricane Beryl will spur governments and international donors to dedicate greater attention to building resilience across economic sectors, especially around enhancing the climate and disaster resilience of critical infrastructure.

The world must pivot from passively accepting that disasters will occur to actively preventing them through investment in disaster risk reduction. Otherwise, every hurricane will inevitably lead to disaster.

To this I say, amen.

Special note: This article was completed after the 8.01 a.m., magnitude 5.3 earthquake that occurred last Friday, August 16, according to the UWI Earthquake Unit. It was located at approximately six kilometres northeast of St Andrew. The focal depth was 27 kilometres.

Cedric E. Stephens provides independent information and advice about the management of risks and insurance. For free information or counsel, write to: aegis@flowja.com or business@gleanerjm.com