In Part I of this series on weather and climate risk management, I reviewed the context within which organizations seek to manage climate and weather-related risks. With extreme weather events becoming more common, there are recent international treaty commitments, global and national bodies developing ESG risk management standards, and new SEC regulatory compliance, and reporting requirements for US publicly traded companies. These developments are placing greater scrutiny on the need for better weather risk management. In Part I, I also provided a high-level review of enterprise risk management approaches for managing weather risks. After considering common approaches to risk avoidance, risk acceptance, risk sharing, and risk mitigation, I identified some of the common weather risk transfer triggers:

• Above (below) a specified amount of rainfall over a specified period at a specified place.
• The number of times the temperature fell below (rose above) a specified temperature over a specified period in a specified place.
• Catastrophic events, such as earthquakes, floods, drought, tornados, hurricanes, hail, and cyclones in a specified period at a specified place.
• Greater than normal variances in temperature, precipitation, snowfall, snow depth, hail, windspeed, humidity, sunshine, and water flow in a specified period at a specified place.
• Heating degree days (HDDs) and Cooling degree days (CDDs): that is, measurements of how warm (cold) a specified place is against a standard temperature, typically 65 degrees Fahrenheit.
• Crop yield-reducing events, such as dry weather, wet weather, frost, and heat in a specified period at a specified place.

In Part II, we pick up where we left off in Part I. I investigate popular weather risk transfer products that businesses can consider as part of their enterprise risk management systems, and their decision making on how to best transfer certain economic risks associated with extreme weather events.

What are the popular insurance products?

Popular insurance products include traditional indemnity insurance and parametric insurance.

What is indemnity insurance?

Traditional indemnity insurance requires a policyholder to prove it has incurred an actual loss in order to receive a payout on the policy. Indemnity insurance typically has five characteristics:

• The policyholder must have an insurable risk, meaning that it must have both a legal and an economic connection to an asset, item, or activity subject to the insurable risk.
• The policyholder must transfer its risk of loss to an insurance company in exchange for the insurer indemnifying it against the possible loss because of that risk. The policy payout is limited to the lesser of the policyholder’s actual loss or the maximum dollar amount covered by the policy.
• The policyholder must pay a premium to the insurance company for the insurer to assume the policyholder’s insurable risk.
• The insurance company typically holds a larger pool of contracts covering similar risks so there is a risk distribution or risk spreading across the of similar risks.
• The policyholder must demonstrate that its loss resulted from an insurable risk.

What is parametric insurance?

Parametric insurance is an increasingly popular way to manage weather risk. It is referred to as “parametric” because its payoff is triggered by the occurrence of an agreed-to set of metrics (triggers). Parametric insurance can be issued to cover events that are difficult to insure with indemnity insurance, with insurers offering customized policies for seasonal, annual, and multi-year periods. Parametric insurance allows a business to transfer risk to an insurance company, while streamlining the way in which it must prove a loss.

Parametric insurance uses objective, measurable metrics to trigger a quick payout without a protracted claims process. Since payoff occurs when agreed-upon triggers take place, a policyholder is protected against that predetermined event happening. In order for the parametric insurance to qualify as insurance, the policyholder must notify the insurance company of the amount of its loss incurred, and the payout must be limited to the amount of the loss caused by that event. Payout triggers rely on objective data from specific weather stations or other monitoring systems that are specifically identified in the insurance contract.

What happens when a payout is triggered?

Once a trigger event occurs, the policyholder alerts the insurance company to the amount of its loss, and the policy pays out a specified amount. The payout amount can be tied to various degrees of severity of the predetermined metric. For example, if a payment is triggered for a hurricane, the payout might be 50 percent for a Category 2 wind speed; 75 percent for Category 3; and 100 percent for Category 4. Once the trigger event occurs, the policyholder files its proof-of-loss claim and receives a payment based on the trigger, up to but not exceeding its actual loss.

What is a good definition of parametric insurance?

The National Association of Insurance Commissioners (NAIC) describes parametric insurance as follows:

“An example is a policy that pays $100,000 if there’s an earthquake with a magnitude of 5.0 or higher. The contract needs to specify the payment amount, the trigger (in this case, the earthquake magnitude), and a third party that checks if the trigger happened. Usually, a government agency, like the National Earthquake Information Center, does this. There might be backup verifiers in case the main agency can’t do it. For example, if the earthquake damages the sensors of the National Earthquake Information Center so that their issuance of an official magnitude is delayed, another agency’s reading will be used so that payment is still timely.”[1]

Does the broader availability of more accurate data allow for the increased use of parametric insurance as a weather risk management tool?

Yes. Parametric insurance has become increasingly popular. “Hazard modelling continues to improve, while weather stations and satellites capture more accurately weather-related parameters. Improved data and models enable parametric cover as an increasingly efficient, affordable, and viable option in the market.”[2]

Because indemnity and parametric insurance are appropriate for different risks, might a policyholder obtain both types of insurance as part of its weather risk management strategy?

Yes. Parametric and traditional indemnity insurance are often purchased together. As Marsh McLennan noted in its report, “Parametric Insurance: A Tool to Increase Climate Resilience,” “Parametric covers are not intended to replace traditional insurance—but to complement them and speed up recovery. They can be designed to cover both specific catastrophic losses and frequency losses—for example the business interruptions caused by a hurricane or the impacts of decreased snowfall.”[3] As a result, traditional indemnity policies and parametric policies can work together. “Parametric covers can be especially useful when there is a lack of capacity or appetite from traditional insurance markets, especially for risks that are typically underinsured or uninsured or where the impact of the event is related to business interruption losses that are greater than the direct costs of the loss or damage of physical assets.”[4]

Are weather derivatives a risk management tool that a business might use to manage weather risks?

Yes. A common way to manage weather risk is through weather derivatives. Weather derivatives are financial contracts entered into between two parties where the contract value is derived from performance of an underlying weather index or weather benchmark trigger. Weather derivatives can be standardized, exchange-traded contracts, or they can be customized, over-the-counter (OTC) contracts. Weather derivatives—both exchange-traded and OTC—can be structured as futures, forwards, options, caps, floors, collars, and swaps. Strike prices, contract values, and payouts are tied to weather-related factors, with the most common payouts being temperature-based HDDs and CDDs.

The first reported weather derivative transaction was an OTC transaction entered into in 1997. Exchange-traded weather derivatives on HDD and CDD futures and options followed closely behind in 1999 at the Chicago Mercantile Exchange (CME) and in 2001 at the Intercontinental Exchange (ICE). Both the CME and ICE currently offer futures and options on HDD and CDD indices for various population centers and energy hubs throughout the United States, Europe, and Japan.

Are weather derivatives increasingly attractive for managing weather risk given the trend towards extreme weather events?

Yes. Given 2023’s extreme weather events and record-breaking temperatures, the weather derivatives market saw a significant expansion in 2023. Continued growth is likely in 2024 and beyond. Reuters compiled some interesting statistics on 2023 weather derivatives activity,[5] reporting the following:

• Average open interest in CME weather futures and options was four times higher in January to September of 2023 than it had been during the same period in 2022
• Average open interest was 12 times higher in 2023 than it had been in 2019
• Trading volume quadrupled from 2022 to 2023.[6]

Market demand for OTC weather derivatives is also expanding. For example, around 70 percent of the OTC weather derivatives entered into in the United States are quoted on ICE Chat,[7] giving [ICE] direct access to the most comprehensive weather derivatives market data available. To further expand this rapidly growing OTC market, ICE Chat uses this data to foster market liquidity and encourage members of the energy community—suppliers of electricity, heating oil, and natural gas, in particular—to become involved in the weather derivatives market.[8]

What are the types of exchange-traded weather derivatives?

Exchange-traded weather derivatives consist of standardized futures contracts and options on futures contracts that are backed by the exchange clearing house—so that the clearing house becomes the buyer for all sellers, and the seller for all buyers.

What are popular types of OTC weather derivatives?

OTC weather derivatives are customized bilateral agreements, often taking the form of options, caps, floors, or swaps.

What is an example of an option?

An option generally provides one-sided protection to the purchaser in exchange for payment of a premium. With a call option, the buyer has the right—but not the obligation—to call the underlying property from the seller to it. With a put option, the buyer has the right—but not the obligation—to put the underlying property to the seller of the option.

What is an example of an option floor?

If an electric utility wants to protect itself against unseasonably low demand for electricity in its usually peak summer cooling months, it might purchase an option floor that entitles it to a payment from the floor writer (seller) if the aggregate number of CDDs in the designated floor period is below an agreed-upon level. If the aggregate number of CDDs during the designated floor period is at or above the agreed-upon level, neither party has an obligation to make any payments. The utility is simply out of pocket the amount of the up-front option premium it paid to purchase the floor. In other words, the floor protects the utility from a decline in revenue because it sells less electricity in the designated time period.

What is an example of an option cap?

A cap agreement is similar to a floor, except that it relates to, for example, rainfall exceeding an agreed-upon level during the designated time period. If an amusement park wants to protect itself against an unseasonably wet season, it might purchase a cap that entitles it to receive a payment from the cap writer (seller) if the aggregate amount of rainfall in the designated cap period is above the agreed-upon level. With a cap, the cap buyer is protected if there is more rainfall than expected during the designated period. If there is less rainfall, the amusement park is out the amount of the premium it paid, and it does not receive a payout.

What is an example of a swap?

In a weather swap, one party agrees to pay the other party if (for example) snowfall exceeds an agreed-upon threshold amount during designated periodic payment dates. The other party agrees to pay the first party if the amount of snowfall is below an agreed-upon threshold amount. A ski resort that wants to protect itself against unseasonably low snowfall could enter into such a weather swap to receive a payment from the other party if the aggregate snowfall in the designated payment period is below an agreed-upon level. Unlike the one-way protection available with a floor or a cap, however, the ski resort is obligated to pay the other party if the aggregate amount of snowfall in the designated payment period exceeds the agreed-upon level. Because a swap requires both parties to assume risks in opposite directions, a weather swap is generally entered into “at market” and does not involve an up-front premium payment by either party.

Conclusion

Organizations that manage enterprise-wide climate risks have available to them various weather risk transfer products. In Part I of this Q&A series, we had looked at climate and weather risk management at a high level. In Part II, we looked at weather risk transfer products. Next, in Part III, I address the regulation of these products. And, to close the series in Part IV, we will take a deep dive into the taxation of these products.

In the preparation of Weather & Climate Risk Management, an occasional series from ASKramer Law, 
I want to extend my gratitude to Brian O’Hearne, CEO of Hailios, for his comments.

[1] “Parametric Disaster Insurance,” National Association of Insurance Commissioners, December 21, 2023. https://content.naic.org/cipr-topics/parametric-disaster-insurance.

[2] “Parametric Insurance: A Tool to Increase Climate Resilience,” Marsh McLennan, 2018.

[3] Ibid.

[4] Ibid.

[5] “Use of Weather Derivatives Surges as Extreme Climate Events Rock the Globe,” Harry Robinson, Reuters, Oct. 11, 2023. https://www.reuters.com/markets/global-markets-weather-derivatives-analysis-pix-2023-10-11/

[6] Ibid.

[7] ICE Chat is a messaging system hosted by ICE where users can communicate with other users in real time, to view trade opportunities, trade quotes, messages sent to a large group, and communicate with other market participants.

[8] “ICE Tips—ICE Chat Weather Data Feed,” https://www.ice.com/publicdocs/knowledgecenter/chat/ICEChat_Weather_Data_Feed.pdf