The financial health of a number of industry sectors is directly exposed to changes in weather patterns (e.g. energy firms, insurance and agriculture). This exposure creates unpredictable fluctuations in their cash flow and constitutes a serious business risks. These risks can trickle down the economic chain to suppliers, clients and other economic actors. For a Gas Supplier for example, cold winters create a favourable environment for the company, whereas mild winters potentially create cash–flow problems with suppressed volumes and a subsequent fall in prices. In the same vein, some geographical zones are exposed to natural elements such as hurricanes in US Southern States or cyclones in the Asia Pacific basin.
Before the emergence of weather derivatives, insurance has been the main tool of choice used by businesses for protection against weather risks. But insurance only protects against the consequences of the weather i.e. catastrophic damage. Insurance offers a very limited protection against a host of other risks caused by the weather.
In general, weather derivatives are more flexible than insurance contracts because they can cover low–risk, high–probability events. They can also cover localized weather events that may not be part of a general weather pattern. Weather insurance, on the other hand, typically covers high–risk or extreme events with typially low–probability of occurence. Weather insurance ploicy also tends to be a highly customized. Counterparties wishing to convert an insurance policy into a derivative or vice versa, use "transformers". Transformers provide a bridge between weather insurance and the weather derivatives market. Weather insurance and derivatives are parallel markets. A transformer is a special purpose vehicle that purchases protection via an insurance policy and may write a swap in exchange.
In established markets, weather derivatives have a variety of structures especially in OTC markets. These include:
• Contracts - Swaps, Calls, Puts, Collars, Exotics, Baskets, etc.
• Term – Monthly, Seasonal, Multi-Year, etc.
• Limits – Most transactions capped to create finite exposures
• Hybrids – Weather-linked financings, securitizations, quanto hedges
ISDA has developed standard forms for weather contract confirmation and the use of Credit Support Annexes are utilized.
The Weather Risk Management Association has:
• Developed standardized confirmations
• Specified settlement language / data
• Identified locations as “back-up” stations for primary locations
• tested aspects of the contracts through the bankruptcy of two industry
participants.
Companies that are subject to public disclosure to regulators or their shareholders must demonstrate that the purchase or a sale of a derivatives is true and fair hedge, not speculation. SFAS 133 and IAS provides guidelines on the steps that are required.
In some case weather derivatives seats at the in intercepts between two type standards, "accounting standards for insurance contracts" and "accouniting standards for weather derivatives contracts". The complexity increases with the involvement of transformers. As special purpose entities they fall within the scope of different accounting standards. Under US GAAP, a number of accounting standards apply to SPEs, most notably FIN 46R that sets out the consolidation treatment of these entities. There are a number of other standards that apply to different transactions with SPEs. Under International Financial Reporting Standards (IFRS), the relevant standard is SIC12 (Consolidation–Special Purpose Entities).
When they are standardized and traded on exchanges, weather derivatives will fall within the scope of SFAS 133. EITF Issue No 99–2 "Accounting for weather derivatives" provides guidance on accounting for weather derivatives that are not exchange–traded. All written non–exchanged–traded option–based weather derivatives contracts should be carried at fair value with subsequent changes in fair value reported in current earnings. Entities that enter into speculatives or trading non–exchange derivatives contracts should apply the intrinsic method. Weather derivatives accounting came under severe criticism in the wake of the collapse of Enron. As a large market maker Enron was effectively prescribing the value of majors contracts.