Mitigating Drought-Related Financial Risks for Water Utilities via Integration of Risk Pooling and Reinsurance

Abstract

Concerns over drought-related financial risk have been growing for water utilities as adaptive measures, such as conservation (which reduces revenues) and water transfers (which increase costs), play larger roles in drought management. Recent research suggests that both utility-specific and generalized forms of index insurance can play an effective role in managing a water utility’s drought-related financial risk. However, any entity offering these contracts to the water utility sector, whether a third-party insurer or a “mutual” formed by multiple utilities, will need to manage the “tail” risks of severe or widespread drought impacting many utilities simultaneously, which has the potential to drive high aggregate financial losses. When managing these risks, this entity must balance the opportunity costs of capital associated with higher reserve funds against the costs of mechanisms for transferring this tail risk (e.g., reinsurance). This research characterizes the financial risks of drought for a mutual, composed of surface water utilities distributed across all 344 climate divisions of the contiguous United States, that insures utilities against drought-related financial losses using contracts based on the Palmer Hydrologic Drought Index (PHDI). Tradeoffs associated with the mutual’s risk management strategy involve varying levels of reserves and reinsurance. Results show that risk pooling via a mutual combined with reinsurance coverage can reduce the average annual net cost of risk management for member utilities by 7.5% while significantly reducing the average total net cost over 10-year periods by 17%.