March 08, 2022
Extreme rainfall, snowfall, wind, and temperature all impact investment valuations. Capital advisors, asset managers, and ESG officers face increasingly complex and nuanced risks. Demex Climate Risk Appraisals provide a new management strategy for climate resilience.
Climate Risk Appraisals from Demex directly address future business performance. Lenders appraise climate-driven shifts for risk of borrower defaults. Business owners appraise climate-driven shifts in costs and revenue. Investors appraise climate-driven shifts in projected returns across their portfolios. Appraisals are the essential starting point for climate risk management. They form a pathway toward Demex derived parametric insurance and weather hedging for complete financial solutions.
A New ESG+R Normal: Extreme Weather
Climate change is driving weather patterns to become increasingly unstable and presents shifting risks for businesses. As weather patterns change, many scientists agree that extreme weather is the “new normal.” In 2021, the Washington Post found that over 40 percent of Americans lived in a county impacted by extreme weather.
With extreme weather comes new and increasing costs. In 2021, there were 19 events with total costs between $1-Billion and $25-Billion per event. 15 of those events cost between $1-Billion and $2-Billion each. At Demex, we call these extraordinary weather events “Kits” to distinguish them from larger natural catastrophes (aka “Cats”) which cost over $25-Billion.
Losses from Kits have increased 5-fold since the ’80s:
- In the 1980s, Kit losses were $23-Billion
- In the 1990s, Kit losses were $43-Billion
- In the 2000s, Kit losses were $52-Billion
- In the 2010s, Kit losses were $111-Billion
Shifting Capital Risks
In response, more and more companies are examining their exposure to climate-related risks. Credit rating agencies, government regulators, investors, and the Task Force on Climate-related Financial Disclosures (TCFD) are all directing companies to understand and manage their Climate Linked Economics. ESG+R programs are no longer optional; effective climate risk management is a necessity. Business leaders, investors, and regulators are demanding increased transparency on climate impacts.
These impacts are felt differently by different players in the financial system:
- Lenders appraise the risk of borrower defaults.
- Business owners appraise shifts in profitability.
- Investors appraise projected returns across their portfolios.
Demex provides comprehensive customized risk assessment for capital groups, asset managers, and management consultants who work with clients that are at risk from shifting climate.
Climate Risk Appraisals put a dollar value on extreme weather linked to specific capital investments and management strategies. Appraisals directly address future business performance.
With a clear picture of the dollar value of risk, clients achieve profitability through informed strategic decisions. Appraisals are the first step for managing climate risk through parametric insurance and climate hedging.
Example: North Carolina Property Exposure
Demex’s customer is concerned about their property portfolio’s exposure to increasing extreme rain events.
Demex first assessed the customer vulnerability of the region, quantifying local rainfall trends in North Carolina.
The map above is the result of Demex’s climate assessment where -100 (dark blue) is getting much drier and 100 (dark green) is getting much wetter.
Demex then incorporated the client’s portfolio locations and assessed customer exposure. On average, the portfolio was impacted by steadily increasing rainfall trends.
PROBLEM: Averaging across the portfolio fails to tell the whole story.
A pattern emerged as we assessed the local trends. After assigning scores for trends in rainfall and variability in rainfall, our customer’s properties cluster into two groups that are impacted differently.
The locations clustered in Group A experienced decreased variability year-to-year. In other words, rainfall patterns are becoming more reliable and easier to estimate. The locations clustered in Group B experienced increased variability year-to-year. In other words, rainfall trends are becoming unreliable and harder to estimate.
Then, we calibrated the assessment using customer-provided (first party) financial data. We appraised the risk at each location. We separated this analysis by group, isolating the client’s reliable from the unreliable properties.
The resulting maps, shown below, quantify the financial risk at each location in the portfolio.
The size of the bubble of each location corresponds to financial exposure, with the largest bubble indicating maximum financial exposure. The color of each location corresponds to the trend at that location, with gray indicating a neutral trend in rainfall, darker green is getting wetter, and darker blue is getting drier.
SOLUTION: Coupling economic impact with weather trends at each location demonstrates the total climate impact.
This Demex Climate Risk Appraisal simulates 5,000 years of precipitation and client financial data to build a sophisticated projection of expected operating margins.
We calculated the associated loss (in millions) per weather event by level of severity. Results range from a very severe (1 in 100 year) rainfall event to a standard (1 in 2 year) rainfall event. We enhance the analysis by including the effects of shifting rainfall patterns. Adjusting loss for the full scope of recent climate trends yields the climate impact, leading to a difference over $1 million.
In this case, including climate trends negatively impacted operating margins by an average of 20%. Accounting for climate impact appraises the true value of climate impacts.
But what can you do about it?
Risk transfer options for total climate risk include parametric insurance that will protect in years where operating margins are depressed.
Market hedging: This client could pay $2.2 million in premium and limit year-to-year variance by $3.7 million, visualized below.
Trend adjusted hedging: Adjusting for climate trends, however, builds a more effective and efficient risk-transfer. Trend-adjusted hedging costs $1 million in premium and decreases variance by $4.2 million, both visualized below.
Each scenario is visualized above, with cost curves simulating the probability (y-axis) of different expected loss scenarios in millions of dollars (x-axis.)
The trend-adjusted hedging best narrows the variance in expected loss, with the tightest potential outcomes.
For this client, adding Demex active risk management leads them to outperform alternative strategies by 150%.
Demex provided an end-to-end solution for this client, beginning with appraising the client’s climate risk and ending in offering coverage options tailored to protect the client against that risk.