By Robert Holmes
Breaking it down, revenue equals price plus volume. You can set your price for snow and ice management services, but the weather will determine the volume of service that is performed. It is also the variable over which you have absolutely no control and may be the single greatest risk to your company’s financial success from year to year. How can snow contractors protect themselves from this great unknown?
Financial solutions exist that help to transfer a large portion of the risk to a third party. These solutions fall into two categories: insurance policies and derivative contracts. Each can provide the needed transfer of the financial risk of either too much or too little snowfall, but the implementation of each differs greatly.
To purchase or sell snowfall derivatives, commonly referred to as “contracts” or “hedges,” the buyer and seller must be an eligible contract participant (ECP). There are several classifications of an ECP, but eligibility basically boils down to the financial status of the business. An ECP must have either a net worth of at least $1 million or have at least $10 million in assets. Also, there is no requirement that either party must have a potential for a loss, and these contracts can be used to speculate.
Years ago, an attempt was made to provide and grow a market for exchange-traded snowfall derivatives at the Chicago Mercantile Exchange. The market failed to materialize into a useful transfer of risk due primarily to a lack of participants and, therefore, liquidity. Currently, derivatives are only available over-the-counter (OTC), which means availability is through a broker-dealer. This is an important distinction since OTC-placed contracts are not protected from counterparty default.
Derivatives are regulated at the federal level through a variety of agencies, most notably the U.S. Commodity Futures Trading commission with additional oversight by the Securities and Exchange Commission. Any disputes or issues must be brought before federal regulators.
A snowfall insurance policy has an insurable interest that is memorialized on the insurance application. The policy can be purchased through any properly licensed insurance broker and can be placed with financially strong admitted insurance carriers. In some cases, only where coverage is either not available through the standard insurance markets or the limits are large, it is permissible to obtain coverage through the London markets.
Snow insurance policies, like other insurance products, are highly regulated by the insurance commissioner of the purchaser’s domiciled state. The broker providing the insurance must have a valid insurance producer’s license to solicit, consult upon, and/or receive compensation for the sale of insurance. If the buyer of an insurance policy has any issues, or feels that they have been treated unfairly, they may contact the state insurance commissioner’s office.
Tax and accounting impact
From a taxation standpoint, a snowfall insurance policy is generally treated no differently than any other types of insurance you purchase. Premiums are typically deductible and taxes are not due on a claim payment as the claim payment offsets the loss associated with the extreme in snowfall. A derivative contract is typically treated differently. The premium is not typically deductible, and any payment received will most likely be taxed.
Accounting for derivatives can be complex. Neither your insurance agent nor derivatives dealer should provide you with, nor should you rely on, any tax or accounting advice, if given; you should seek the advice of your own accounting, tax and legal professionals before transacting.
Derivatives and insurance policies have been used for decades to transfer risk. Which one is right for your business depends on many factors. Regardless of the mechanism, be sure to ask questions and seek the advice of others, especially with regard to accounting and taxes.
Understanding the differences
Snowfall derivatives are exotic 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. Contracts are available from derivative dealers and are regulated at the federal level.
Snowfall insurance is a policy designed to contain costs or a reduction in revenue associated with abnormal weather conditions. Coverage is obtained through licensed insurance agents and is regulated by each state’s insurance commissioner.
Robert Holmes is a meteorologist, and founder and president of Spectrum Weather and Specialty Insurance, recently named the nation’s top weather insurance brokerage by Insurance Business of America. Contact him at firstname.lastname@example.org or at 816-810-2346.