Weather Derivatives: "How to Insure Against a Rainy Day"

From Nautilus:

We are all familiar with the concept of insurance. Your home insurance protects you against fires, theft, and flooding. Your car insurance protects against serious accidents—not running out of gas. Life insurance… well, you know. With the notable exception of health insurance, the insurance industry is geared toward protecting us against the extraordinary event. It is part of how we have come to terms with the uncertainty in life. But in protecting against unfavorable weather, companies are starting to push the boundary of the insurable well into the mundane, everyday event. And they can do this courtesy of a financial instrument called a derivative.

After hundreds of years of seemingly adequate coverage by standard insurers, companies have realized the caprices of daily weather can be as costly as major storms. Employing innovative financial instruments, a wide range of weather-dependent businesses are banking on derivatives to shield their profits from Mother Nature.

One of the first weather derivative agreements involves everyone’s favorite energy company, Enron.¹ In 1996, Koch Energy, owned by Kansas billionaires Charles and David Koch, approached Enron to negotiate something like an insurance policy. But it was not something they could buy from regular insurers. They weren’t looking for insurance against a catastrophic event like a hurricane or a blizzard, something that might damage their plants or pipelines. Instead, they wanted protection from something much less alarming: a warm winter in Wisconsin in the following year. Their profits depended on the demand for natural gas, and warm winters, when people used less heat, were costly. So Koch and Enron entered into a negotiation over probabilities.

Enron agreed to pay Koch an amount based on a measure of energy consumption called a “Heating Degree Day” or HDD. The HDD compares the average temperature outside with the temperature at which people commonly turn the heat off in their buildings—say, 65 degrees. If the daily temperature over a winter averaged 35 degrees, Koch would sell enough gas every day to produce 30 HDDs worth of heat. An average temperature of 50 degrees would cut those sales to 15 HDDs, slicing revenues in half. The two companies agreed that Enron would pay Koch $10,000 per HDD if the temperature fell below a predetermined level, and Koch would pay Enron a set fee if the temperature rose above the agreed-upon trigger point. After this early experiment, derivatives became standardized so that the buyer and seller settle the contract at the end of the weather season or year—as opposed to standard insurance practice, where the premium is paid upfront—and the seller pays if the temperature reaches a preset threshold.

Like a standard insurance policy, then, Koch and Enron were buying protection from one another. Unlike a standard insurance policy, the payout was not based on after-the-fact damage assessment. No insurance claims adjuster was involved, and no proof of damage was required. The payout was, instead, indexed mathematically to exact, pre-agreed-upon metrics: the data collected at a particular set of Milwaukee weather stations. The contract was signed far in advance of any reasonably accurate weather forecast.
A smattering of other weather derivative deals were made in 1996, as well. Aquila Energy and ConEd arranged for a derivative based on “Cooling Degree Days,” the inverse of HDDs, using data from the weather station in Central Park in New York City. Since then, the market has grown rapidly. The roster of weather derivative buyers now includes ski slopes and golf courses, wind and solar energy farms, the biggest public utilities and oil companies, crop farmers, and airlines. These financial instruments can be bought and sold on publicly traded markets like the Chicago Mercantile Exchange, which trades in standardized weather derivatives and estimates that more than $25 billion worth were written in 2012. Koch Industries has become a significant player in the market, both selling and buying derivatives.

They wanted protection from something much less alarming: a warm winter in Wisconsin the following year.

To see the appeal of a weather derivative to a buyer, consider the John F. Kennedy International Airport in New York City. The Port Authority of New York, which manages the airport, expects a little more than 23 inches of snow a year.  Bordering the Atlantic Ocean on Jamaica Bay, JFK has 25 miles of taxiways and 9 miles of runways. According to Martin Malinow, president of Endurance Global Weather, a company that writes weather-related derivatives to cover risks not already handled by standard insurance policies, it could cost an average of approximately $1 million an inch to clean snow off this network.  “If you have a year that is very snowy —50 inches—they are going to incur an extra $27 million in expenses,” says Malinow....MUCH MORE