Parametric insurance solutions are a valuable form of transfer to manage climate and other natural disaster risks, explain Marc Paasch and Richard Zhang
While the world continues to navigate through the ongoing pandemic, the impact of climate change intensifies.
Last December, many northeast Asian countries experienced one of the coldest winters recorded in years. China was forced to restrict electricity use in several provinces; South Korea’s main grid set record high demand for power; Japan’s spot electricity prices soared more than 10-folds to record levels and the general public was asked to voluntarily restrain its consumption of electricity.
Extreme weather can impact many industries, but this no longer can be an excuse for volatile revenues, higher costs or disappointing earnings. Although weather change is an uncontrollable factor, companies can control and mitigate their financial impact from weather-related risks. Insurance solutions such as parametric are increasingly recognised as a valuable form of transfer to manage climate and other natural disaster risks.
Parametric insurance is an innovative solution that can protect companies against financial losses on pre-defined events. It is not a replacement for traditional insurance but complements and fills the protection gaps in traditional insurance programme.
Instead of paying a claim based on value of a loss incurred, parametric insurance pays out a predetermined value, upon occurrence of a triggering event. This is typically related to parameters such as wind speed, temperature, precipitation, wildfire burn area or even number of credit card transactions or transport-related delay.
So, what are the benefits of using parametric insurance?
Simplicity of claims settlement and speedy payment
In the wake of a natural disaster, the best way to help a business with its cash flow disruption is to provide cash fast. Parametric insurance pay-out is agreed in advance so that claims can be paid within days rather than months unlike traditional insurance. Comparing to other disaster financing mechanism like contingent credit facilities, parametric insurance payment can be made rapidly without the obligation of paying back.
Transparent coverage with additional capacity in hard market
In a hard market, parametric insurance provides supplement capacity to companies when the overall capacity is restricted in tradition insurance. It is more appealing to capital providers as parametric insurance offers greater transparency and contract certainty. Both the insured companies and insurers have access to same data for underwriting and claims settlement. This eliminates adverse selection and moral hazard issues due to information asymmetry.
Through extensive use of data on pricing, parametric insurance radically simplifies underwriting process. It saves embedded costs and reduces amount of time required to quote and bind a policy. The transparent, objective and non-ambiguous nature of parametric trigger virtually removes the need for a loss adjustment, and in general, increases efficiency and lowers the cost of the insurance programme.
As marginal cost is minimal, parametric insurance is often more cost-efficient and competitive in the market.
Insuring the ‘uninsurable’
In the past, parametric insurance solutions mainly applied to catastrophe risks. But the boundaries defining what is ‘uninsurable’ are being increasingly pushed to new limits. For example, wind supply sufficiency is an intangible asset valuable to the wind energy business and this is not covered by traditional insurance. If persistent wind diminishing occurs as a result of an unforeseen long-term weather phenomena, the actual financial performance of a wind investment could be significantly different from how it was originally projected. The coverage for such financial loss is beyond what traditional insurance can provide.
Parametric insurance can address the protection gap by providing coverage against financial loss as a result from unfavourable weather conditions, natural disasters or even loss of business due to pandemics, cyber-attacks and even damage of intellectual property or to company’s reputation.
Opportunities for parametric insurance growth in Asia
According to Swiss Re, about 75% of global agricultural production is not insured. Weather risk is associated to almost 60% of yield variability and thus a crucial factor in influencing food production and farmers’ income. In many Asian countries, complex terrain, poor transportation facilities and inadequate weather infrastructures constrain the development of agriculture insurance solutions. With the rapid development of remote sensing technology and data analysis skills, parametric insurance can be used to quickly used to improve the insurance coverage area.
The World Bank, Asia Development Bank and other international institutions actively participate in pilot projects of parametric agriculture insurance in Asian countries. In 2020, China has set its targets to develop the country’s agriculture insurance to a global advanced level by 2030. The agriculture insurance premium in 2021 is estimated to be over $15 billion and more than $45 billion in 2030. Innovative parametric insurance will play a critical role in this development.
Similarly, parametric insurance has been increasingly used in the agriculture sectors in Myanmar, Thailand, India, Taiwan, Vietnam and other Asia countries.
Today, Asia accounts for nearly half of the global renewable-energy capacity, according to the International Renewable Energy Agency. Around 400 gigawatts of combined wind and solar capacity are likely to be added in Asia over the next five years. With the significant shift of energy production to wind, solar and hydro, the influence of weather risks becomes a critical factor.
Renewable energy output can substantially be affected by major droughts, floods or prolonged periods of insufficient wind or solar resources. Parametric insurance is frequently used to reduce financial risks by large utility-scale renewal energy investments against such weather risks.
The Asian Development Bank estimates that Asia Pacific needs $26 trillion of infrastructure investment by 2030. According to GlobalData, Governments and public authorities will likely be advancing their spend on infrastructure projects as soon as normality returns so that they can reinvigorate the construction industry and the wider economy.
Construction projects face various weather risks like hurricanes, thunderstorms, extreme rain, hot or cold waves. Significant delays may result, leading to severe financial losses even if the project does not sustain any physical damage. Parametric insurance can provide an efficient risk transfer mechanism to mitigate these weather risks for large construction projects. Construction parametric insurance is expected to grow with the advanced infrastructure investments in Asia post-pandemic.
What lies ahead?
In the last four years, parametric insurance has seen strong growth in Asia. Based on Willis Towers Watson’s data, the number of parametric insurance transactions in Asia have increased by over eight times from 2017 to 2020. About 55% of these are weather-related cases (including 13% from agriculture and 27% from renewable energy), 35% on natural disasters and the remaining 10% on pandemic, reputation, footfall and other non-damage business interruption cases.
Although regulatory approval is still required for parametric insurance transactions in most Asian countries, the requirements may differ considerably in different jurisdictions. Factors such as insurable interest, basis risk, indemnity feature and industries where parametric solutions can be used are important considerations.
While the use of parametric insurance has been increasing across industry sectors in Asia, not all companies have seized the opportunity. Parametric insurance can complement traditional indemnity insurance with unique advantages and benefits to satisfy customers’ more sophisticated risk-transfer demand. It is becoming a key alternative risk transfer solution that can increase companies’ resilience to climate risks and help to close Asia’s protection gap.
We have seen how climate change and the record-breaking weather in northeast Asia has impacted the power industry last year. Extreme weather events are not going to stop and will become more common. And if this happens again, are you ready?
Marc Paasch is global head of Alternative Risk Transfer Solutions and Richard Zhang is Asia head of Alternative Risk Transfer Solutions, Willis Towers Watson.