Weather derivatives: call them insurance: defrocking weather derivatives and classifying them as what they are, insurance products, can only serve to benefit the public, claims the National Association of Insurance Commissioners.

Editor's note: The following is a summary of a draft white paper titled Weather Financial Instruments: Insurance or Capital Markets Products? published by NAIC.

Virtually every business is subject to some fiscal impact by the weather, which can cause earnings to fluctuate from year to year depending on weather conditions. A prudent business will account for its weather risks and take appropriate risk management measures to guard against financial loss by using weather insurance.

Weather insurance was initially sold to the outdoor entertainment industry as rain insurance for sporting events, musicals, county fairs, outdoor charity events and film screenings. Over time, contracts involving both temperature and snowfall have been added to simple "rainy day" contracts in response to market demands and need for businesses to protect themselves from the financial consequences of inclement weather.

Now, one of the largest buyers of weather insurance is the energy industry. Taking advantage of the possibilities that deregulation offered, entities like Enron, Aquila and others decided it would be a good idea to offer financial instruments such as derivatives, weather hedges, and swaps to protect their earnings against unpredictable weather. Thus these entities embarked on a campaign to buy, sell and trade these risks among themselves and in the capital markets as "non-insurance" risk transfers. This ultimately resulted in the creation of a multibillion-dollar industry.

The energy trading business started rather innocently as their initial intent was for the energy provider to create a financial hedge against the consequences of change in demand for energy. Mild temperatures depress the demand for natural gas or heating oil, while extremely cold temperatures cause demand to rise beyond their capacity to deliver the product, causing them to seek added supplies on the market. Either of these circumstances potentially cause financial loss to the business.

Generally, businesses that are involved in accepting risk transfers for a fee are known as insurers and the fee paid by the entity seeking to transfer its risk is know as premium.

Energy traders have gone to great lengths to train those providing the energy contracts to use terminology that distinguishes them from weather insurance products. Nevertheless, a weather insurance product and a weather derivative apply the same seven common elements. The policy specifies the named insured, the policy period, the coverage limits, the peril insured against, the premium, the weather reporting station and the trigger of coverage. Although sometimes carefully crafted to have different nomenclature, [there are] legitimate concerns about whether weather derivatives are truly capital markets products or are simply insurance products that are misclassified as such. Of further concern, there are several reinsurers that offer weather insurance products as a reinsurance contract for energy providers. There are several regulatory issues and concerns in this area.

Classification of these "derivatives" as insurance would provide consumer protections that are associated with the regulation of insurance. Purchasers of the insurance contracts can expect that state regulators will be reviewing the contracts for compliance with state law. The rates and rating systems applied to the contracts would be subject to scrutiny to assure that the rates charged are not excessive, inadequate nor unfairly discriminatory.

These weather financial instruments are and should be classified and regulated as insurance products for the benefit of the public. Energy traders need to limit their trades to the commodities that they market and leave the risk transfer of the financial consequences to those that are in that business; namely insurers.