NPR ran a story this week on how airlines and other business are using futures contracts on snowfall “as a type of insurance policy against the weather.”
Weather derivatives can be a useful instrument for hedging, and hedging is a kind of insurance policy. But it is useful to keep in mind how a futures contract is different from an actual insurance policy.
A futures contract is written on a very specific commodity price or other well specified index. The snowfall futures contract is based on measured snowfall at a given location–such as Chicago’s O’Hare Airport–within a given month. It has a payoff that is very mechanically tied to that index. If snowfall impacts an airline’s business by cutting into revenues from flights, then buying a futures contract on the amount of snowfall may help reduce the total volatility of cashflow.
The catch is that the correlation between the loss of business and the amount of snowfall is imperfect. The futures contract doesn’t payout the amount of an airline’s losses. It’s payout is determined by the index, and the index isn’t always a good signal of the airline’s losses. The number of flights canceled is likely to be greater if the snow is concentrated in a couple of heavy storms than if it is spread out evenly throughout the month. But the futures contract payout will be the same in both cases. Similarly, two storms with comparable snowfall may have very different impacts on the complicated network of flights:
This is where insurance policies have an advantage. When I have an automobile accident, my insurance company covers the damage, whatever the damage–less my deductible. If snowfall causes roof damage to my house, my homeowner’s insurance covers the repairs. It doesn’t make the payout contingent upon total snowfall in the month, regardless of whether I have any damage or not. The payout is contingent on the scale of the damage. When hurricane Andrew struck Florida in 1992, causing enormous damage, it was the scale of the damage actually done that caused the large insurance payouts, not the measure of windspeed or quantity of rainfall. A hedging strategy using futures contracts doesn’t have this flexibility to make the payout contingent on the actual losses incurred. This is another example of basis risk.
Of course, in order for insurance contracts to offer this extra benefit of making the payout match the loss, they have to hire adjusters to investigate claims. Obviously there is room for a disagreement between me and my insurer over whether my auto or home claim is really covered by my contract and reimbursable, and what is the actual size of the loss. This distinctive feature of insurance–that the payout is directly tied to the amount of damage–is a costly feature. The transactions costs–in the form of adjusters, appraisals and disputes–are high. Futures contracts have low transactions costs by making the payout contingent on an easily measured index. But the tradeoff is that a payout linked to this index doesn’t quite match the losses.