Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. Weather derivatives are index-based instruments that usually use observed weather data at a weather station to create an index on which a payout can be based. This index could be total rainfall over a relevant period—which may be of relevance for a hydro-generation business—or the number where the minimum temperature falls below zero which might be relevant for a farmer protecting against frost damage.
As is the case with parametric weather insurance, there is no proof of loss provision. Unlike “indemnity” insurance-based cover, there is no need to demonstrate that a loss has been suffered, however an indemnity insurance policy for weather is a rarely utilized instrument. Settlement is objective, based on the final value of the chosen weather index over the chosen period. If a payout is due, it is usually made in a matter of a few days with the settlement period being defined in the contract
Farmers can use weather derivatives to hedge against poor harvests caused by failing rains during the growing period, excessive rain during harvesting, high winds in case of plantations or temperature variabilities in case of greenhouse crops; theme parks may want to insure against rainy weekends during peak summer seasons; and gas and power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth earnings. A sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold.
Heating degree days are one of the most common index types for weather derivative evaluation. Typical terms for an HDD contract could be: for the November to March period, for each day when the daily mean temperature falls below a reference point (65 degrees Fahrenheit in the U.S., or, 18 degrees Celsius outside the U.S.), a cumulative count is kept of the daily departures from the reference temperature. Such an accumulation can be the basis for a derivative contract which might be structured as an option (call or put) or as a “swap” that is an agreement to pay or to receive payment.