What Is Weather Insurance?
The term weather insurance refers to a form of financial protection against losses or damages incurred because of adverse, measurable weather conditions. These conditions generally include wind, snow, rain/thunderstorms, fog, and undesirable temperatures.
Weather insurance as a separate policy is commonly used to protect businesses and their related activities. 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.
- 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 meteorological events can be secured via weather derivatives, a financial instrument to hedge against the risk of weather-related losses.
How Weather Insurance Works
Weather influences our daily lives and can have a huge impact on corporate revenues and earnings. So, weather insurance, taken out in a standalone insurance policy, is commonly used to protect businesses and their related activities—such as insuring an expensive event that could be ruined or severely impacted by bad weather. Weather insurance can cover events like festivals, concerts, trade shows, seasonal events, parades, film shoots, fundraisers, and sporting events. But it can also be used by individuals to cover major celebrations, such as an outdoor wedding.
Conventional weather insurance generally includes coverage for low-probability meteorological events, including hurricanes, earthquakes, and tornados. Insurers would offer reimbursement if weather conditions cause a loss of revenue from events, or the cancellation of them outright.
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%, and would set premium rates accordingly.
Purpose of Weather Insurance
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.
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.
Protection against losses caused by adverse weather conditions is covered to a certain degree by other types of insurance policies, such as homeowners insurance, property insurance, or special event insurance.
Example of Weather Insurance
Let's say an event planner is organizing an outdoor festival for a weekend in the summer. Although they sell tickets to the festival itself, the event organizer also expects to earn revenue from sales of food, drinks, and products—a cut of what various vendors are offering. The organizer sets the date but is unsure about whether weather conditions will cooperate.
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 a poor turnout due to rain, the organizer can file an insurance claim with the insurance company to make up lost revenue, provided premiums are paid up.
Weather Insurance vs. Weather Derivatives
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.
Percent of the U.S. economy that is directly affected by the weather.
Enter weather derivatives. They provide protection of a sort, but they are not insurance—rather, they are financial instruments used by companies or individuals to hedge against the risk of weather-related losses. 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. In the event of unexpected or adverse weather, they pay the buyer of the derivative the agreed-upon amount reimbursement.
Weather Derivatives Background
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 the 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.
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.