What Is Weather Insurance?

The term weather insurance refers to a form of financial protection against losses incurred because of adverse, measurable weather conditions. These conditions generally include wind, snow, rain, fog, and snow, storms, undesirable temperatures. Weather insurance is commonly used to protect businesses and certain outdoor events. As such, these policies serve various purposes, such as insuring an expensive event that could be ruined by bad weather. Insurers cover insured entities if weather conditions cause a loss of revenue from events.

Key Takeaways

  • Weather insurance offers financial protection against a loss that may be incurred as a result of adverse, measurable weather conditions.
  • Premiums are determined by the likelihood of the insured weather event occurring and the amount of potential loss.
  • Conventional weather insurance generally covers low-probability weather, including hurricanes, earthquakes, and tornados.
  • Protection against high-probability events can be secured via weather derivatives.

How Weather Insurance Works

Insurance provides policyholders with protection against losses stemming from a variety of risks, such as death, car crashes, and weather. Insured parties pay insurance companies premiums in exchange for coverage and file claims when they experience a loss. Weather insurance can cover events like festivals, weddings, concerts, trade shows, seasonal events, parades, film shoots, fundraisers, and sporting events.

The premium for weather insurance is based on several factors, including the location and time of year. In other words, the dollar amount clients are charged for coverage is determined by the likelihood of the insured weather event occurring and the amount of potential loss. An actuary at the insurance company looks at weather data going back many decades to decide how to price a policy. If, for example, Cleveland gets a white Christmas every 10 years, then the insurer knows that the probability of such an event is 10%.

Businesses sometimes even use these policies as a sales gimmick to lure in customers. For instance, a furniture store may advertise that all buyers of furniture in December will get their purchases free if it snows more than two inches on Christmas. In such cases, the store would buy a policy to cover this specific event.

Weather insurance is a necessity for many companies and is considered to be a key risk management strategy. It’s also highly customizable. For example, an insured party can choose the number of days, weather events, and severity of weather that will be covered by the policy.

Roughly 20% of the U.S. economy is estimated to be directly affected by the weather.

Weather Insurance vs. Weather Derivatives

Weather influences our daily lives and can have a huge impact on corporate revenues and earnings. Until recently, insurance has been the main tool used by companies for protection against unexpected weather conditions. The problem is that conventional insurance usually only provides coverage for catastrophic damage and does nothing to protect against the reduced demand businesses experience as a result of weather that is warmer or colder than expected.

Enter weather derivatives. In the late 1990s, people began to realize if they quantified and indexed weather in terms of monthly or seasonal average temperatures and attached a dollar amount to each index value, they could "package" and trade weather. The very first transaction of the sort was conducted in 1997 in a power contract by Aquila Energy. From here, the weather became a tradable commodity, comparable to trading the varying values of stock indices, currencies, interest rates, and agricultural commodities began to take shape. 

Important

Protection against losses caused by adverse weather conditions may also be covered to a certain degree in other types of policies, such as property insurance.

The seller of a weather derivative agrees to bear the risk of disasters in return for a premium. That means that if no damages occur before the expiration of the contract, they end up making a profit.

Weather derivatives usually cover low-risk, high-probability events. Weather insurance, on the other hand, typically protects against high-risk, low-probability occurrences, as defined in a highly customized policy. Because weather insurance and derivatives deal with two different possibilities, a company might have an interest in purchasing both.

Example of Weather Insurance

Let's say an event planner is organizing an outdoor festival for a weekend in the summer. The organizer sets the date and is unsure about whether weather conditions will cooperate. Although they sell tickets, the event organizer also expects to earn revenue from sales. In order to make sure there are no hiccups during the festival, the organizer decides to take out a weather insurance policy. If the festival gets bogged down by rain, the organizer can file an insurance claim with the insurance company to make up lost revenue, provided premiums are paid up.