Weather derivative
A financial contract whose payout depends on a measured weather variable, temperature, rainfall, wind, not on damage; it covers the volume risk of energy companies, farmers or event organizers.
A gas distributor suffers no damage in a mild winter, but it sells less, and its result collapses. Property insurance has nothing to offer against this volume risk, since there is no loss event. The weather derivative answers it by indexing a payment to a variable measured by an official station. The most common index is the degree-day: over a period, one adds up the daily gap between average temperature and a reference threshold, to measure how cold a winter or how hot a summer was. The contract sets a strike level and an amount per degree-day: if the winter is milder than expected, the buyer is paid proportionately. Born in the US energy sector in the late 1990s, this market is organized in standardized contracts listed on derivatives exchanges and in tailor-made over-the-counter contracts. It requires no proof of loss, which makes it fast and dispute-free, but it carries basis risk: the reference station's temperature may differ from the one that actually drives sales. The line with parametric insurance is thin; it lies mainly in legal form, accounting and whether an insurable interest is required.
Hypothetical case: a gas distributor buys a derivative paying 20,000 euros per heating degree-day short of a 2,400 threshold over the winter, measured at the regional airport station. The winter records only 2,250: it receives 3 million euros, which offsets most of its lost sales.
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