A portfolio of weather risk transfer contracts efficiently reduces risk

Abstract

We quantify the potential reduction of risk in practice that is possible by constructing a portfolio of contracts covering weather risks, relative to a portfolio of lower-frequency natural catastrophe risks. First, we illustrate a protection seller’s analysis and reservation price for individual weather risk contracts during a winter period of underwriting. The objective is to earn a requisite return on capital on behalf of the protection seller’s investors while meeting the risk management objectives of the buyer. We use Monte Carlo simulation to compare portfolios of these contracts and observe how optimizing the portfolio can reduce risk and the potential combined cost of the weather risk transfer contracts. Although both weather and natural catastrophe portfolios can be diversified by peril geography and type, we note that additional diversification can be achieved in weather portfolios along the dimension of peril direction due to buyers’ interests in taking opposite sides of weather indices. This is evidenced by our calculation of negatively correlated payouts of weather contracts, something that is harder to achieve for payouts of natural catastrophe contracts. We show that risk reduction of a portfolio of weather risk transfer contracts could potentially exceed that of a portfolio of diversified lower-frequency natural catastrophe contracts. This could enhance the risk-adjusted financial performance of protection sellers. These findings imply that protection buyers, including the most vulnerable organizations and people, could experience lower risk premiums, making weather risk transfer more affordable.

Keywords

• Portfolio risk
• Risk reduction
• Parametric insurance markets
• Weather risk
• Natural catastrophes