Winnipeg Free Press - PRINT EDITION

Betting on the weather grows in popularity

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A salon in Atlanta has used them to avoid taking a financial haircut in years when the weather is extra nice and fewer people want to be stuck indoors getting their hair done.

Closer to home, a local pool and spa retailer used one this summer to make a splash with the media and its customers.

Climate insurance, anyone?

The low-down on weather derivatives and weather insurance contracts:

What are they? Wikipedia defines weather derivatives as financial instruments that can be used to reduce the risk of adverse or unexpected weather conditions -- things like hurricanes, tornados, floods, droughts or heavy snowfalls. The insurance industry also refers to weather insurance contracts as "contingency coverage" or "rebate coverage."

How long have they been around? Since 1996, when a weather clause was included in an energy-sale agreement between Aquila Energy and Consolidated Edison Co.

Who sells them? Specialty insurance brokers and specialty firms like WeatherBill Inc. and MSI Guaranteed Weather sell over-the-counter weather insurance contracts. And the Chicago Mercantile Exchange has also been trading weather derivative contracts since 1999.

Who uses them? Some of the more common users are farmers and agriculture companies, theme parks, special event organizers/managers, travel agencies, gas and power companies, municipalities and retailers.

What are they used for? The two most common uses are for risk management and marketing/promotion. An outdoor event organizer, for example, uses them to protect against revenue losses due to bad weather. And retailers use them to generate publicity and boost sales.

How much do they cost? There is no standard model for calculating cost. It can vary according to how much the buyer can afford to pay, how big the payout would be and the likelihood of a payout, among other things.

What kind of growth has the industry seen? According to a recent Brock University study, the weather derivatives market has grown from about $500 million in sales in 1998 to $45.2 billion in March 2006. They're expected to reach $200 billion by 2016.

 

-- Sources: Wikipedia, Brock University, IC Specialty Brokers and Simmlands Insurance Services Ltd.

The deal was that if the temperature hit 34.5 degrees Celsius on July 18 -- it just missed -- nearly every customer who bought a pool, spa, heat pump or commercial hot water tank between March 1 and July 4 would have been eligible for a full refund.

And a Winnipeg car dealership has been using them for the last five years to drive up sales during a traditionally slow time of the year -- November and December.

In its case, at least 10 centimetres of snow had to fall in Winnipeg on Jan. 12 for every customer who bought a vehicle in the previous November or December to receive a $10,000 rebate.

In all three cases, the products they used were over-the-counter weather insurance contracts. The contracts are available through specialty firms and insurance companies, and the Chicago Mercantile Exchange also sells a similar product called a weather derivative contract.

While weather derivatives and weather insurance contracts have been around since 1996 and have enjoyed phenomenal growth, Brock University finance professor Don Cyr said in an interview the best is yet to come.

"You're just starting to see it take off," Cyr said, adding there are two things driving the growth: more insurance companies offering them and the weather becoming increasingly volatile and unpredictable.

"And that creates greater risk."

He said weather contracts allow companies and organizations to hedge against things they otherwise couldn't insure against.

That could include too many sunny weekends, too much rain or too much snow.

Cyr co-authored a recent Brock University study into the usefulness of over-the-counter derivatives as a snowfall risk management tool for municipalities. The study concluded they can be effectively used to hedge against the financial risks associated with unexpectedly high snowfalls. It also predicted they'll become more widely used as weather conditions become more volatile due to global warming.

A spokesperson for the City of Winnipeg said it seriously considered using them about three or four years ago to offset the risk of high snowfall-removal costs. Although it already has a reserve fund in place for that, it wanted to see what other risk-management options it might have, said Shelley Davidson, acting corporate risk manager.

"But it was determined at that point in time the cost and the risks of going in that direction outweighed the benefits."

However, Davidson said circumstances can change, so the city will likely reconsider them at some point.

Cyr said cost may be one reason why more cities aren't using weather contracts. Lack of awareness may be another.

He said the lack of an agreed pricing formula is a hindrance. Because there are so many variables involved in determining the cost of a contract, prices are all over the map.

One rough guideline he has heard is five to 10 per cent of the potential payout. But a spokesman for local insurance broker IC Specialty Brokers said the cost can be as low as 1.5 per cent. And a spokesman for Toronto-based Simmlands Insurance Services Ltd. said it could be as little as 0.75 per cent and as high as 20 to 30 per cent. Or in some cases, more.

The general sales manager of North West Wholesale said it paid less than two per cent of the insurance company's potential payout of $553,000.

"It was a lot less than I thought," Chad Spiring said. "I figured we would have to pay six or eight per cent."

The general sales manager of the local auto dealership -- Winnipeg Dodge Chrysler Jeep -- declined to reveal how much it paid.

"But it's not very expensive," Domenic Sacco said.

Sacco and Spiring both said it was money well spent.

"It's fun, and the customers love it," Sacco said. "It really brings a lot of cheer and excitement into the entire purchasing process."

"And for the insurance premium we paid, we got 10 times the advertising value," Spiring said, noting their contest garnered national media coverage.

"We were on the front page of the Free Press on a Saturday," he added. "You can't even buy that spot."

murray.mcneill@freepress.mb.ca

Republished from the Winnipeg Free Press print edition August 27, 2011 B4

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