Weather Derivatives:

Global meteorological research institutions estimate 80 per cent of the business activity in the world is weather-sensitive. Weather is the largest cause of price volatility, volume fluctuations and revenue loss in many industries worldwide, according to the Weather Risk Management Association (WRMA). There’s a lot of weather risk out there and, in the face of climate change, businesses and their financial advisors are looking for new solutions to protect their revenue and control costs from volatile weather. Many of these businesses in weather-sensitive industries are turning to a decade-old financial tool to make their profit predictable, even when the weather isn’t.

During the mid-’90s, investors in the United States created a weather index based on monthly and seasonal average temperatures and began trading weather. The contracts were called weather derivatives and the concept was similar to trading agricultural commodities like corn and wheat.

Some of the earliest adaptors of weather derivative coverage were energy companies that used heating degree day (HDD) or cooling degree day (CDD) contracts to hedge their risk of mild winters and cool summers when consumers weren’t turning their heat up or their air conditioning down. Consolidated Edison Company used the first weather derivative in June 1996 as a clause in a power purchase. The clause, which was based on the derivative, stated the power provider would refund Consolidated Edison Co. if the month of August was cooler than forecasted. The refund was based on temperature measurements from a government-affiliated weather station located in New York City’s Central Park. If total CDDs for the month of August were 11 per cent to 20 per cent below normal, Consolidated Edison would be refunded.

A Canadian snowmobile company became one of the first non-energy companies to use derivatives in 1998. Bombardier Inc. offered their snowmobile buyers a $1,000 rebate if that winter had low snowfall. Sales of snowmobiles increased 38 per cent that winter, according to the company, with the bulk of sales taking place months earlier than normal. The promotion ran successfully for two consecutive years, but derivatives remained out of reach — financially and technically — for other similar weather-sensitive companies.

Weather derivatives were soon traded over the counter and eventually exchange-traded on the Chicago Mercantile Exchange in 1999. Today, the applications for weather derivatives have expanded. Once a weather risk management tool used exclusively by energy companies and Fortune 500 businesses, farmers are using weather derivatives to hedge the risk of frost during harvest, baseball teams are covering ticket sales from the risk of rainouts, and car washes are covering rainy weekends.

Similar concepts

While the concept of weather coverage is similar, weather derivatives are different from insurance in many ways. The first is that weather derivative payouts are based solely on measurements at weather stations. There’s no claims process or proof of loss needed for payout. Deductibles are optional and there’s no minimum or maximum purchase required.

Derivatives are regulated by the federal government rather than states. In the United States, the government has mandated that businesses must have a net worth of US$1 million to purchase weather derivatives. Individuals must have US$5 million. These laws apply to Canadians that purchase the coverage from US-based weather derivative providers.

Payout determination is the main difference that makes derivatives attractive for many weather-sensitive industries that have not been able to utilize insurance. For example, citrus growers are protected by crop insurance, but the businesses that depend on those oranges, like packinghouses and juice companies, are not. Specialty crops, like cherries and artichokes, are also not always covered by crop insurance. Weather derivatives cover those previously unmanageable risks. Weather derivatives also work in tandem with crop insurance, adding extra coverage to critical growing stages like harvest.

Another industry that is benefiting from weather derivatives is sports. Many sporting events, including Minor League Baseball and Major League Soccer, depend on ticket and concession revenue to achieve profit goals. Too much rain and profit falls short of expectations. Because weather derivative payout is based on measured weather and not physical loss, ticketed events can get paid for bad weather.

Working with insurance

From 1980 through 2004, the cost of weather-related events totalled US$1.4 trillion (inflation-corrected) globally. Only US$340 billion was insured. While the cause of global climate is debatable, studies indicate that there are weather trends, in both precipitation and temperature, which are affecting businesses. It’s not just the headline-catching hurricanes and tornadoes that are doing the damage. Dr. Evan Mills, a scientist in Berkeley Lab’s Environmental Energy Technologies Division and the Intergovernmental Panel on Climate Change, estimates that 60 per cent of total weather-related losses are attributable to relatively small weather events. For example, there are more economic losses to frost damage in the United States than any other natural hazard including floods, droughts, hurricanes and tornados, according to Professor RL Snyder at UC Davis.

Insurance has historically been, and continues to be, one of the best solutions for covering the threat of catastrophic weather-related damage. But business can be interrupted and profits lost because of a downpour or a couple hours of frost. As the threat of climate change increases, insurance companies are quickly seeking new products to address new weather trends. A 2007 study of insurance companies around the world found there is 15 times the number of climate change-related products than there were in 1999 (Risk to Opportunity 2007: Insurer Responses to Climate Change). However Ceres, a non profit coalition of investors, environment and public interest groups, found that only one-third of insurers are offering innovative products and serves that address the implications of climate change.

Weather derivatives are an important tool to not only weather sensitive businesses, but to the insurance industry. No two businesses are alike; therefore weather risk management requires as many coverage options as possible. While not every weather- sensitive business can benefit from derivatives — most of which don’t cover hail, wind or lightening — it is important to offer business owners as many tools as possible to mitigate their risk.

Weather derivatives go mainstream

In 2006, two people saw a way to eliminate weather risk for all businesses, regardless of size or industry and became the first to sell derivatives direct to insurance brokers.

“Our goal was to democratize weather derivatives,” David Friedberg, CEO of WeatherBill, said. “A bike rental business down the street from my home closed every time it rained. The owner and his revenue were completely dependent on good weather; something completely out of his control. I thought, ‘there’s got to be a financial product that can lessen that blow’.” So, he set out to do just that.

Derivatives have been more accessible by addressing three issues that prevented early-stage weather derivatives from reaching all weather-sensitive businesses, regardless of industry or size.

The first issue is accessibility. Originally, derivatives were only available to large companies with several millions of dollars at risk from bad weather. This is not the case anymore. The second issue is complexity. The process of creating contracts was time-consuming and prevented exchanges from taking on small risks. Coverage is now automated and available online. The third issue is that weather derivatives were only available through exchanges. The risk is now taken on directly and backed by reinsurance fund managers.

Weather derivatives in action

Five inches of snow at an airport isn’t something most travelers hope for, but there are many Canadians hoping for just that. The “Let It Snow” promotion guarantees that Canadians who purchased a vacation package from itravel2000.com will be refunded the retail price of their vacation if it snows more than five inches on Jan. 1, 2009.

Travelers qualify for the promotion based on their home postal code. If it snows five inches or more at their local airport (Halifax, Montreal, Toronto, or Calgary) on Jan. 1, they get a free trip. Last year, five inches of snow fell at the airport in Montreal and thousands of travelers won free trips. With a potential $1 million payout at risk, “Let It Snow” is the largest weather promotion in Canadian history. In 2008, itravel2000’s “Let it Snow” delivered a 30 per cent to 40 per cent year-over-year increase in advance sales for the company.

Regina Sinsky is the public relations manager for WeatherBill. She joined the company in 2007 after three years as a writer and producer for CBS news affiliates in Charleston, SC and San Francisco, CA.