Weather & Climate Risk Management Part IV: Taxation of Weather Risk Management Products

Are there differences in the way in which weather derivatives and weather insurance are taxed?

Yes. Weather insurance products, including parametric insurance, are taxed as insurance; and derivatives are taxed in accordance with the tax rules applicable to the particular type of derivative product held by the taxpayer. A business needs to carefully consider these tax differences to determine the best product or products to meet its weather risk management needs.

How is insurance taxed to a policyholder?

When a business buys weather insurance, it pays a premium to the insurance company so that the company assumes the business risks set out in the policy. Assuring the policy is purchased to manage a business’s legitimate weather-related risk, the premium is deductible under Internal Revenue Code (Code) § 162 as an ordinary and necessary business expense.

If insurance coverage is triggered and a policyholder receives a payout under the policy, the payout is not taxable up to the policyholder’s tax basis if the payment reimburses the policyholder for property damage or loss. In other words, payments under insurance policies are not taxable up to the policyholder’s tax basis because the payments simply restore (in whole or in part) the policyholder to the financial position it was in before it incurred the loss. If the reimbursement amount under the policy exceeds the policyholder’s tax basis, the amount it receives over its tax basis is treated as taxable income.[1]

Business interruption insurance covers losses (such as lost profits and ongoing expenses) from events that close or disrupt the normal functioning of the policyholder’s business. The payout amount is often based on past business results. Business interruption insurance proceeds are likely to be taxable to the policyholder because they compensate the policyholder for lost revenue.

To ensure that a policyholder receives the most favorable tax treatment, it must carefully document its business purpose for entering into the insurance, the amount of its tax basis, and receipt of the insurance proceeds.

How are derivatives taxed?

It depends on whether the taxpayer has entered into a futures contract, forward contract, option, swap, cap, or floor. The taxpayer must then consider its status in entering into each derivative: is it acting as a hedger, dealer, trader, or investor? The taxpayer must also determine whether it has made all the required tax identifications and elections. In dealing with derivatives, the taxpayer must go through this three-step process for each product it is considering. Hedgers and dealers receive ordinary income and loss on their derivative transactions, while traders and investors receive capital gain and loss.

Why might a taxpayer want to be treated as a hedger with respect to its weather derivatives?

A taxpayer seeking to use weather derivatives to manage its weather-related business risks typically wants to be treated as a tax hedger so that the gain or loss on its derivative transactions qualify as tax hedges. This would allow the taxpayer to match its derivative gains or losses with its weather-related income or losses. Because ordinary property generates ordinary income or loss, a business hedger typically wants to receive ordinary income or loss on its weather derivatives. In other words, a hedger wants to match the tax treatment it receives on its hedges with that of the items it is hedging. Many risk management transactions with respect to weather-related risks do not meet the hedge definition (see the discussed below). For a detailed discussion of the tax hedging rules, see the forthcoming Q&A with Andie, “Business Taxation of Hedging Transactions.”

What is required for a weather derivative to be treated as a tax hedge?

To qualify as a tax hedge, the transaction must manage interest rate fluctuations, currency fluctuations, or price risk with respect to ordinary property, borrowings, or ordinary obligations.[2] In addition to meeting the definition of a tax hedge, the taxpayer must comply with the identification requirements set out at Code §§ 1221(a)(7) and 1221(b)(2) and the tax accounting requirements set out at Treas. Reg. § 1.446-4.[3]

What is the tax analysis that a taxpayer should conduct to determine if its weather derivatives qualify as tax hedges?

When entering into a weather derivative, a taxpayer should conduct the following tax analysis: (1) is the transaction entered into in the ordinary course of its trade or business (2) primarily (3) to manage price risk (4) on ordinary property or obligations (5) held or to be held by the taxpayer. If the answer to all of these questions is “yes,” then the taxpayer has a qualified tax hedge if—but only if—it complies with all of the required identification rules set out in Code §§ 1221(a)(7) and 1221(b)(2) and as explained in Treasury Regulation § 1.1221-2. If the taxpayer cannot answer all of these questions with a “yes,” then the weather derivative transaction is not a tax hedge, and it is subject to the tax rules that apply to capital assets.[4] The requirement that a taxpayer must be hedging ordinary property, borrowings, or obligations means that favorable tax hedging treatment is not available for many legitimate weather risk management activities.

What types of assets, obligations, and borrowings qualify as ordinary property and ordinary obligations for purposes of the tax hedging rules?

Weather derivatives qualify as tax hedges if they can be tied to price risk with respect to ordinary assets or ordinary obligations. In many situations, however, weather derivatives are entered into to manage a taxpayer’s anticipated profitability, sales volume, plant capacity, or similar issues. These risks are not the transactions that receive tax hedge treatment.

Ordinary property includes property that if sold or exchanged by the taxpayer would not produce capital gain or loss without regard to the taxpayer’s holding period. Items included in a taxpayer’s inventory—such as natural gas or heating oil held by a dealer in those products—are treated as ordinary property that can be hedged. Qualifying hedges can also include hedges of purchases and sales of commodities for which the taxpayer is a dealer, such as electricity, natural gas, or heating oil. If a utility agrees to purchase electricity at a fixed price in the future, for example, the utility is exposed to price risk if it cannot resell the fixed-price electricity for at least the amount it paid to purchase that electricity. Accordingly, the utility could agree to sell electricity under a futures contract (short position) that would qualify as a tax hedge.

On the liability side of a business, the hedge could relate to a taxpayer’s price risk with respect to an ordinary obligation. An ordinary obligation is an obligation the performance of which (or its termination) would not produce a capital gain or loss. For example, a forward contract to sell electricity or natural gas at a fixed price entered into by a dealer is treated as an ordinary obligation. In addition, a utility that enters into a fixed price forward sales contract agreeing to sell electricity at a fixed price has an ordinary obligation to deliver electricity at that fixed price.

What sorts of weather derivative transactions are not tax hedges?

Many legitimate risk management activities do not qualify as tax hedges. Weather derivative transactions that protect overall business profitability (such as volume or revenue risk) are not directly related to ordinary property or ordinary obligations. As a result, weather derivatives entered into to protect a business’s revenue stream or its net income against volume or revenue risk are not tax hedges.

Many taxpayers in the normal course of their businesses enter into weather derivatives to manage volume or revenue risks of reduced demand for their products or services. These transactions are not tax hedges. The taxpayer is not managing a price risk (either current or anticipated) attributable to ordinary assets, borrowings, or ordinary obligations.

Take, for example, a ski resort or amusement park operator that enters into a weather derivative to protect itself against adverse weather conditions that are likely to result in a reduction in the number of skiers or amusement park visitors. The taxpayer’s risk management efforts in these cases either relate to its investment in its facility (which for the most part consists of real estate and business assets that are not taxed as ordinary assets) or to its expected revenue. Similarly, a power generator that hedges its plant capacity or its revenue stream with a weather derivative tied to the number of Cooling Degree Days would not meet the definition of a tax hedge.

Why don’t more weather derivatives qualify as tax hedges?

As part of Congress’ efforts to modernize the tax rules with respect to hedging, it specifically authorized the Treasury to issue regulations to extend the hedging definition to include other risks that the Treasury sets out in regulations.[5] The Treasury, unfortunately, has not proposed or issued any regulations extending the benefits of tax hedging. This means that weather derivative transactions entered into to manage weather-related volume or revenue risks do not qualify as tax hedges. In this situation, the taxpayer receives capital gain or loss on the derivative product.

What are some examples of weather derivatives that can qualify as tax hedges?

A weather derivative qualifies as a tax hedge if it manages the taxpayer’s price risks with respect to ordinary assets or obligations. Thus, a taxpayer entering into weather derivatives primarily to manage its price risk with respect to increased supply costs will meet the definition of a hedging transaction. Such a transaction manages the taxpayer’s price risks with respect to ordinary property.

If, for example, a commodity dealer buys a put option (or sells a call option) on a designated weather event to protect it against price risks with respect to its existing inventories or future fixed-price commitments, the dealer has entered into a qualified tax hedge, provided it meets the identification requirements.

A heating oil distributor with heating oil inventory (or forward contracts to purchase heating oil at a fixed price) might enter into a weather swap to protect itself from the risk of an unseasonably warm heating season. This swap should qualify as a tax hedge because the swap manages the distributor’s risk of a decline in the market price for its heating oil inventories (or a decline in its fixed-price forward contract purchase commitments) due to unseasonably warm weather.

If an electric utility enters into forward commitments to sell electricity at fixed prices for delivery in the summer cooling months, it may buy a call option on a designated weather event that would qualify as a tax hedge to the extent the option protects the utility against the risk of being unable to acquire or generate the electricity at a low enough price if the demand for electricity in the cooling season is higher than expected because of unseasonably warm weather resulting in higher electricity prices.

Conclusion

All organizations face weather and climate risks. As part of their enterprise-wide risk management, they have available to them a number of weather risk transfer tools. This series on weather and climate risk provides a detailed review of weather risk management. Organizations can look to standardized futures and option contracts traded on regulated commodity exchanges; they can enter into customized OTC weather derivatives designed with their specific weather risks in mind; they can put in place indemnity insurance; they can purchase parametric insurance; or they can mix and match multiple derivative products and insurance coverages to meet their specific organization’s needs. In Part I of this Q&A series on Weather & Climate Risk Management, we considered the landscape and context within which weather and climate decision making takes place, along with the overarching risk management approaches and principles that apply. In Part II, we looked at the details on the various weather risk management products. In Part III, we addressed the regulation of these products; and in Part IV, we reviewed the taxation of these various classes of products.


[1] Taxability is subject to a nonrecognition provision at Code § 1033(a) if the taxpayer complies with the requirements to purchase “qualified replacement property.” https://irc.bloombergtax.com/public/uscode/doc/irc/section_1033

[2] Treas. Reg. § 1221-2 and Code §§ 1221(a)(7) and 1221(b)(2).

[3] For a detailed discussion of the tax hedging rules see my forthcoming Q&A with Andie, “Business Taxation of Hedging Transactions” due out in Spring 2024.

[4] If the taxpayer is a dealer or a commodity derivatives dealer, the weather derivative would be an ordinary asset in the taxpayer’s hands.

[5] Code § 1221(b)(2)(A)(iii).

California Enacts Legal Protections for Cannabis Insurance Providers

Several cannabis-related bills were signed by California Governor Gavin Newsom on September 18, 2022, including Assembly Bill 2568 (AB 2568), which clarifies that it is not a crime for individuals and firms licensed by the California Department of Insurance (CDI) to provide insurance or related services to persons licensed to engage in commercial cannabis activities. Though the California Civil Code was amended in 2018 to clarify that cannabis is the legal object of a contract, and it has been tacitly understood that insurance contracts are legal in California, the intent of this new law is to remove any uncertainty and to encourage further growth of admitted insurance products for California cannabis businesses.

AB 2568 adds section 26261 to the California Business and Professions Code, which states in relevant part: “An individual or firm that is licensed by the Department of Insurance does not commit a crime under California law solely for providing insurance or related services to persons licensed to engage in commercial cannabis activity pursuant to this division.”

Intent of the Law

The California Assembly’s Committee on Insurance explained the intent behind AB 2568 in a report issued earlier this year:

“The hesitancy of insurance providers to provide insurance for commercial cannabis is attributed to risk, since cannabis is classified as a Schedule I substance under the Federal Controlled Substances Act. Therefore, much of the insurance available in California is from surplus lines. This does not align with the federal government’s longstanding determination that it is in the public’s interest for states to regulate their own insurance marketplaces. Further, the argument has been refuted in federal case law brought about in Green Earth Wellness Center v. Attain Specialty Insurance Company (2016), which established that federal classification of cannabis is not relevant in an insurance provider’s determination to write an insurance policy.

It is important that commercial cannabis businesses have multiple options for insurance as they pursue licensure. AB 2568 clarifies that writing insurance for commercial cannabis does not constitute a crime, since cannabis is part of a legal, regulated market in California. This clarity will provide assurances to admitted insurers that they will not be in violation of any regulations and encourage them to provide an insurance product.”

In addition, AB 2568 was strongly supported by CDI, which argued that “we must provide commercial cannabis businesses with multiple, affordable options for insurance as they pursue and maintain state licensure.” CDI supports AB 2568 in part to “promote reliable insurance coverage for all aspects of these cannabis businesses to ensure that these businesses can continue to flourish just like any other business in this state.”

In a separate analysis, the California Senate Committee on Insurance inquired as to whether the bill would achieve the intended result of expanding insurance options for cannabis businesses. It concluded:

“This bill expressly states a protection under California Law for CDI licensees. This protection has been implied since the legalization of recreational cannabis in 2016, and in that same year a federal court gave a nod to insurers that writing cannabis [insurance] is permissible, but only one admitted company has fully waded into the market. On the one hand, insurers are famously risk averse, so this express statement of state law may go a long way for some to take the risk to sell cannabis coverage. But, federal illegality of cannabis could always be the larger barrier to entry for some companies than what the state laws say.”

The Senate report concludes that more study is needed to “consider additional efforts to effectuate the stated goal of growing the domestic market for cannabis insurance.”

Analysis

AB 2568 does not materially change existing California law since providing insurance services to properly licensed California businesses has been legal under state law since at least 2018. The bill, however, is meant to remove any lingering doubt on the topic and to encourage more insurance service providers to enter the market.

As we have previously reported, it is reasonable to conclude that the risk-benefit calculus has adequately shifted to justify entrance into the cannabis market without an unreasonable fear of prosecution. This certainly is true for the insurance industry.

Congress continues to prohibit the Department of Justice and other federal agencies from spending money to prosecute conduct that complies with state medical marijuana laws. Federal law enforcement, meanwhile, has not initiated any prosecution against a plant-touching or ancillary business involved in either adult-use cannabis or medical marijuana where the underlying marijuana business activity was compliant with state law and there was no other independent violation of law.

Despite this favorable outlook, it must be acknowledged that, without a change to the status quo, some degree of theoretical legal risk remains present for any plant-touching or ancillary business in the marijuana industry. Any decision to provide insurance-related services to the cannabis industry must be based on a well-informed understanding of the legal risks and the very challenging operating environment for state-licensed cannabis companies.

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