- Adapting economies to climate-related impacts has become a major priority.
- Parametric insurance – which pays out depending on the severity of an event – could be a game-changer.
- Here's how it works – and why it is especially suited to developing economies.
Extreme weather events strain and test electric grids, gas pipelines and other energy infrastructure and highlight vulnerabilities. They test developed and developing nations alike – especially in places that have not invested enough in upgrading and hardening infrastructure.
Natural disasters worldwide caused $268 billion of economic losses in 2020. Insurance covered only a small fraction of this figure. Insured loss estimates from major natural catastrophes in 2020 were about $78 billion. With economic losses from catastrophes growing faster than insured losses, adapting economies to climate-related impacts has become a major societal priority.
Swiss Re has estimated that the global protection gap in 2020 was $113 billion (lower than the 10-year average of $143 billion), reinforcing the significant level of uninsured losses that occur from catastrophe events.
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Industries most at risk
Extreme weather can impact many industries, leading to volatile revenue, higher costs, disappointing earnings or even insolvency and bankruptcy. Industries with high weather-related risks include:
Cold snaps, heat waves, floods, hail and wildfires can all destroy crops. About 75% of global agricultural production is not insured, even though weather risk is associated with almost 60% of yield variability and thus is a crucial factor in influencing food production and farmers’ income.
Construction projects face various weather risks such as hurricanes, thunderstorms, extreme rain, tornadoes, and heat waves or cold snaps. Significant delays may result, leading to severe financial losses even if the project does not itself sustain physical damage.
The tourism industry is particularly sensitive to hurricanes, floods and tornadoes. A storm’s impact can outlast the weather event by months and even years. For example, tourism accounts for 6.5% of Puerto Rico’s economy; the territory saw record crowds of 8.1 million in 2016. Hurricane Maria struck in October 2017, devastating the island. In 2019, the number of tourists visiting the island was still down 36% from 2016 levels. For those with insurance, property policies were slow to respond, with claims often taking years to settle.
With the significant shift of energy production to wind, solar and hydro, weather risks becomes a critical factor. Renewable energy output can be substantially affected by immediate events such as hurricanes, hail, droughts, floods or long-term events such as degradation of wind patterns. There is also the risk of prolonged periods of insufficient wind or solar resources.
Potential economic game-changer
Although extreme weather is uncontrollable, companies can mitigate its financial impact through insurance. One of the fastest-growing forms is known as parametric insurance. Originally created as a form of catastrophe insurance, parametric insurance is finding additional uses to protect against extreme weather, other natural disaster risks, cyber risk and terrorism.
Parametric insurance can protect companies against financial losses from pre-defined events. In developed economies, parametric solutions are not necessarily a replacement for traditional insurance, but complementary; they fill the protection gaps in traditional insurance programmes. But in developing economies where traditional coverage may not even exist, it could be a game-changer.
Instead of paying a claim based on the value of a loss incurred, parametric insurance pays out a predetermined value, upon occurrence of a triggering event with, usually, the pay-out value increasing as the event intensity increases. In the case of catastrophes like extreme weather events, typical parameters might include wind speed, temperature, precipitation, hailstone size, wildfire burn area or even transport-related or production delays. Industry indexes such as Revenue Per Available Room (RevPAR), Revenue per Passenger Kilometer (RPK), or simple footfall or passenger load can also be used where they are correlated to multiple triggering events.
For example, New Jersey rarely experiences sustained winds over 60 miles per hour. When Super Storm Sandy made landfall near Atlantic City in October 2012, it did so with sustained windspeeds of 80 miles per hour. If a business along the state’s shoreline, which was devastated by Sandy, had a parametric policy that triggered at 75 miles per hour, then they’d have received a payout by the end of the week – the storm made landfall on a Tuesday. (If they had a trigger based on central pressure, the program would have paid more as Sandy had the central pressure characteristics of a Category 3 storm. Surge height would also have been a suitable index for this region.)
Parametric insurance has become very competitive in the market. Through extensive use of data for pricing, parametric insurance radically simplifies the underwriting process. It saves embedded costs and reduces the amount of time required to quote and bind a policy. The transparent, objective and non-ambiguous nature of a parametric trigger removes the need for any traditional loss adjustment process, and in general, increases efficiency and lowers the cost of the insurance programme.
But perhaps the biggest benefit of parametric insurance in the wake of an extreme weather event is the speed of the potential payout. Cashflow disruption is often the biggest challenge facing businesses after a natural disaster and can be the difference between insolvency and continued operation. Parametric insurance can provide cash, fast. Because parametric insurance payouts are agreed in advance and based on independent data providers like the National Hurricane Center, claims are paid on a pre-agreed schedule (usually within days) rather than on a moving schedule over months to even years with traditional insurance. Compared to other disaster financing mechanisms like contingent credit facilities, parametric insurance payments can be made rapidly without the obligation of paying back.
What’s the World Economic Forum doing about climate change?
Climate change poses an urgent threat demanding decisive action. Communities around the world are already experiencing increased climate impacts, from droughts to floods to rising seas. The World Economic Forum's Global Risks Report continues to rank these environmental threats at the top of the list.
To limit global temperature rise to well below 2°C and as close as possible to 1.5°C above pre-industrial levels, it is essential that businesses, policy-makers, and civil society advance comprehensive near- and long-term climate actions in line with the goals of the Paris Agreement on climate change.
The World Economic Forum's Climate Initiative supports the scaling and acceleration of global climate action through public and private-sector collaboration. The Initiative works across several workstreams to develop and implement inclusive and ambitious solutions.
This includes the Alliance of CEO Climate Leaders, a global network of business leaders from various industries developing cost-effective solutions to transitioning to a low-carbon, climate-resilient economy. CEOs use their position and influence with policy-makers and corporate partners to accelerate the transition and realize the economic benefits of delivering a safer climate.
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A solution for developing economies
Additionally, parametric insurance is well suited for developing economies. As no costly visits are required to assess the losses (we can use countries' Meteorological Agency data, or satellite data), payouts can be made quickly to hard-to-reach insureds in remote locations. Crucially, protection against unpredictable but potentially devastating risks – previously unthinkable with traditional insurance – is now possible and in more places. In contrast, in developed economies with hard insurance markets, parametric insurance provides an option for some type of coverage for organizations that are priced out of the traditional insurance market.
Parametric insurance is also more appealing to capital providers as it offers greater transparency and contract certainty. Both the insured companies and insurers have access to the same data for underwriting and claims settlement. This eliminates adverse selection, moral hazard issues and disputes due to information asymmetry between insurers and the insured.
Whether it is reducing the protection gap, financing resilient infrastructure or improving risk management and return optimization across the financial sector, insurance technology and innovation has a decisive role to play in responding to climate risk and smoothing the world’s transition.
While protection gaps remain an issue as greater costs are borne by the uninsured, these gaps are closing slowly. Innovative risk-transfer structures and new products based on parametric triggers have a central role to play and will continue to help increase resilience of companies and economies to growing climate risks.