DEFINITION of Weather Insurance
Weather insurance is a type of protection against a financial loss that may be incurred because of rain, snow, storms, wind, fog, undesirable temperatures or other adverse, measurable weather conditions. Weather insurance is used to insure an expensive event that could be ruined by bad weather, like an outdoor wedding or an outdoor film production.
BREAKING DOWN Weather Insurance
The premium for weather insurance is determined based on location and time of year, in other words, based on the likelihood of the insured weather event occurring and the amount of potential loss. Weather insurance is highly customizable, the insured can choose, for example, the number of days, weather events and severity of weather that will be covered by the policy.
Insuring Against Mother Nature
Until recently, insurance has been the main tool used by companies for protection against unexpected weather conditions. But insurance provides protection only against catastrophic damage. Insurance does nothing to protect against the reduced demand businesses experience as a result of weather that is warmer or colder than expected.
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 in a sense "package" and trade weather. In fact, this sort of trading would be comparable to trading the varying values of stock indices, currencies, interest rates and agricultural commodities. The concept of weather as a tradable commodity, therefore, began to take shape.
In general, weather derivatives cover low-risk, high-probability events. Weather insurance, on the other hand, typically covers high-risk, low-probability events, as defined in a highly customized policy.
Weather insurance has many uses. Businesses sometimes use these policies as a sales gimmick to lure in customers. For example, a furniture store might advertise that all buyers of furniture in the month of December will get their purchases free if it snows more than 2 inches on Christmas day. The store buys a policy to cover this specific event.
An actuary at the insurance company will look at weather data going back many decades to decide how to price this 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%. If the store sells $100,000 worth of furniture in December, the starting point for pricing such a policy is $10,000. This is a simplified example, but it's the kind of thinking that goes into weather insurance.