Perspectives

Parametric Insurance: A Tool to Increase Climate Resilience

Financial tools to increase climate resilience

Case Study: The river Rhine runs dry

Warming temperatures, prolonged drought, and the intensifying heatwaves across Europe, have resulted in plummeting water levels in the Rhine river, the busiest and most important waterway in Europe

Roughly 80 percent of the 223 million tons of cargo transported by ship in Germany each year travels the Rhine, which connects the country’s industrial heartland to Belgium, the Netherlands and the North Sea. However, with water levels in the river recorded in November 2018 are at their lowest since the 1920s, many vessels unable to pass through the low waters, shipping and the maritime trade have been severely disrupted, pushing up freight costs and resulting in rising industrial commodity prices from building materials to petroleum products. The business interruption losses across sectors are also significant. As a protection against the financial impacts of such events, shipping and manufacturing companies in Germany are looking to insurers for parametric solutions to protect against the unprecedented drop in the water levels of river Rhine.

Such maritime trade and shipping disruptions may become more common events across many other countries as the summer months become longer and hotter, affecting river water levels. The Rhine’s plummeting water levels highlights the value of innovative solutions for managing the direct and indirect financial impacts of increasingly unpredictable severe weather events and evolving weather patterns.

 

Fundamentals and the role of Parametric Insurance

Parametric covers are alternative risk solutions provided by insurance and reinsurance companies that enable organizations to finance or to transfer risk in a non-traditional way. The solutions revolve around a measurable index and are based on predefined triggers or pay out mechanisms – without necessarily needing physical damage to occur. As climate-related weather risks become increasingly complex and unpredictable, the requests for such innovative parametric insurance structures have been increasing.

Parametric insurance (for a definition, see Exhibit 1), also known as index-based cover, is gaining traction, especially for weather-related events. Hazard modelling continues to improve, while weather stations and satellites capture more accurately weather-related parameters. Improved data and models enable parametric cover as an increasingly efficient, affordable and viable option in the market. 

Exhibit 1: Mitigating under-insured climate risks with parametric insurance

Globally, capital markets have successfully structured a number of placements for weather-related indemnity where such risks are not insured or underinsured. Examples can be found in the energy, power, hospitality, infrastructure, financial and other industries.

Parametric cover – A building block for microinsurance to helping vulnerable communities

Parametric-based insurance products can also form the fundamentals of a micro-insurance that insures the basic livelihood and health of financially and economically vulnerable people, usually settled in regions with high exposure to harsh and extreme weather conditions. 

For example, financial institutions can create a program that offers access to credit back-stopped by a parametric such as drought insurance to enable the financial institution to provide farmers with loans for agricultural products such as seeds and fertilizers. 

In this way, parametric-based micro-insurance allows the community to build financial resilience against increasingly complex and severe climate-related natural disasters and subsequently recover more quickly when weather events occur. 

 

Parametric cover puts new spin on traditional insurance products

Parametric covers are not intended to replace traditional insurance – but to complement them and speed up recovery. They can be designed to cover both specific catastrophic losses and frequency losses – for example the business interruptions caused by a hurricane or the impacts of decreased snow fall. As such, it is important to consider how the combination of traditional indemnity policies can work together with parametric solutions to achieve the best results.

Parametric covers can be especially useful when there is a lack of capacity or appetite from traditional insurance markets, especially for risks that are typically underinsured or uninsured or where the impact of the event is related to business interruption losses that are greater than the direct costs of the loss or damage of physical assets. For example, for shipping companies on the Rhine, the direct physical effects of the decreased water level may be non-existent, but the costs of business interruption and associated revenue loss are significant. A parametric cover based on the water-level would help protect against lost revenue in this instance.

Parametric insurance is also being used for a variety of risks beyond climate-related weather disasters. Advances in big data analytics, computing power and modelling processes are building more customized parametric insurance against other specific risks such as cyber, data breach, or even reputational damage.

Challenges and Outlook

It is imperative to understand the challenges of structuring parametric insurances: data quality and risk correlation issues have been significant obstacles for many insurance buyers to decide how their policy covers should be designed and adapted to their specific needs.

As data innovations continue, the range of available alternative risk transfer options will only grow, as more insurers are willing and able to underwrite parametric deals. This increases the options for corporates to insure. The concept of an insurable risk shifts from tangible to intangible risks, and organizations will increasingly require bespoke and innovative solutions to protect against those intangibles. Parametric coverage should be considered as a solution for any risk against which a company can apply an index.

No doubt, the demand for parametric covers will become more mainstream, as the range and impacts of climate-related weather events become more severe and unpredictable. Parametric insurance could become an increasingly viable option for helping organizations build climate resilience and strengthen disaster response and recovery.