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Parametrics offer response to extreme climate events

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Parametrics offer response to extreme climate events

Insurance

Parametrics offer response to extreme climate events

Nascent form of risk finance can help plug insurance protection gap in emerging markets

Typhoon Ursula, which hit the central Philippines on December 25, was the first weather event to trigger a parametric forecast-based index, delivering insurance payouts to affected people © Getty Images

The WEF’s Global Risks Report released this month is a sobering read but, for many, an unsurprising one. For the first time in its 10-year history, all five of the top risks were related to some form of environmental threat, from property-damaging extreme weather to the prospect that efforts by businesses and governments to mitigate climate change will fail. 

According to the report, most companies still seem “ill-equipped” to address climate risk. “Many do not yet quantify physical climate risks in their direct operations and supply chains, and those that do are likely to be underestimating them significantly,” the report notes, leaving them exposed to significant losses in the increasingly likely event of extreme weather or natural disasters.

This “protection gap” is even more stark in emerging markets, where the impact of natural disasters can be particularly devastating. While about 50 per cent of disaster losses are covered by insurance in high-income countries, the corresponding proportion in poorer countries is less than 5 per cent.

Capital markets are an important tool to bridge this protection gap, through risk finance and insurance mechanisms. However, access to finance or traditional indemnity-based insurance products in many emerging markets is constrained due to low penetration and a lack of infrastructure.

Global Parametrics, the organisation of which I am chief executive, is one of several bodies that aim to improve access to cover by means of parametric products. These constitute a type of insurance that covers the probability of a predefined event happening, rather than indemnifying actual loss incurred. They provide payment upon the occurrence of a triggering event (such as an earthquake that reaches a pre-agreed magnitude on the Richter scale) and, as such, are detached from any underlying physical asset.

Such payments in the aftermath of a disaster can help to accelerate essential rebuilding and reconstruction. But, in the case of natural disasters, there is a need for some capital to be in place before the time of impact, or as close as possible to it. This helps to mitigate damage by putting resilience measures in place during the event.

Enter forecast-based indices. These use weather data and monitoring to identify and assess an incoming natural disaster or extreme weather event before it takes place. When the likelihood of impact reaches a pre-agreed limit, payment of funds is automatically triggered.

This is a very nascent type of risk financing and was deployed for the first time by Oxfam and Plan International in their response to Typhoon Ursula, which hit the Philippines on Christmas Day last year. The index tracked Ursula from December 23. On December 24, the payout was triggered, releasing donor funds via electronic cash transfer to those in Salcedo one day before the typhoon hit. This gave people time for making travel arrangements to leave the area or for reinforcing resilience measures against the storm.

Although successful in this instance, such forecast-based triggers have yet to take off outside the humanitarian community. There are still issues with trust in validated forecast indices, particularly in emerging markets where such products have been difficult to establish and where weather data are limited.

But this is changing. Weather models are becoming more sophisticated, and advanced computing is allowing them to be run at higher detail, providing data about even the most remote locations.

Crucially, there is also uncertainty around how parametric products, particularly forecast based-indices, are regulated in many emerging markets. Because such products are relatively new, regulators are unsure whether to class the products as insurance or a straight financial swap. Sometimes they are one, sometimes the other and sometimes both.

Without more regulatory clarity, the buyers of such products may not have a full understanding of what they are buying, and the sellers may not have a full understanding of whether they are allowed to sell, in what form or to whom.

One issue is that, typically, traditional insurance needs an “insurable interest” and a “proof of loss”, while a swap needs a “competent counter party”. Parametrics straddles those lines, making it vital for policymakers and regulators to make it easier for stakeholders to understand which rules apply.

We are still in the very early days. Initially, there may need to be a blending of public and private risk capital in these programmes to give confidence to the market and to build a track record. The market will only be willing to risk private capital in such instruments when their providers can demonstrate robust underlying data, a properly validated claims history and evidence that they are fully scalable — all within the context of a clear regulatory framework.

Hector Ibarra is chief executive of Global Parametrics.

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