Insurance

Using Parametric Insurance to Match Capital to Climate Risk

The year 2019 bore witness to a relentless barrage of climate disasters across the globe. Cyclone Idai wreaked havoc in Mozambique, while deadly heat waves scorched India, Pakistan and Europe. East Africa suffered from a prolonged drought, leading to widespread hunger, and devastating floods displaced millions in Southeast Asia. Record-breaking wildfires ravaged California, and the destruction caused by Hurricane Dorian in the Bahamas and Typhoon Hagibis in Japan added to the global trail of loss and heartbreak.

Extreme weather events such as floods, storms, droughts and heat waves are intensifying due to climate change, with their frequency and severity rising sharply. Since 2000, these disasters have tripled, leading to over 1 million deaths and $1.7 trillion in damages.

What does this mean for insurers?

Three years later, 2022 exposed a heart-wrenching gap between insured losses ($132 billion) and the economic cost of natural disasters ($313 billion). This gap highlights a growing crisis – as extreme weather events become more frequent, they become a financial burden to insurers. This is evidenced by reinsurance premiums surging and reinsurer capital declining.

To navigate this challenging new reality, risk managers are turning to innovative solutions like parametric insurance.

Understanding parametric insurance

Parametric insurance is best understood by comparing it with regular insurance.

Think of regular insurance as a safety net after a storm. You pay premiums to cover specific events like hurricanes, droughts or storms. If one of these unfortunate events strikes, the insurance company reimburses you for the actual financial losses you suffer, up to a pre-set limit in your policy. This process can involve an adjuster visiting your property to assess the damage, making it a bit lengthy.

Parametric insurance, on the other hand, works differently. It is more like a pre-arranged payout triggered by a specific event, regardless of the actual damage. Imagine buying drought insurance for your farm. You agree on a specific amount of rainfall that defines a normal year. If rainfall falls below that threshold (the trigger), you automatically receive a predetermined payout, even if your crop losses are minimal. The payout amount might even be linked to the severity of the drought, with less rain meaning a bigger check. Since the payout is not based on actual damages, there is no need for individual damage assessment. This means you can receive funds within days or weeks of the triggering event, getting you back on your feet faster.

The ‘if-then’ parametric insurance solutions

Many businesses in catastrophe-prone areas are rethinking their approach to climate risk management with parametric insurance. This innovative tool acts as a safety net alongside traditional insurance, offering a quicker and more targeted way to manage financial losses from natural disasters.

Here's why parametric insurance is a good fit:

• ‘If-then’ simplicity: Coverage kicks in when a specific event (the ‘if’) occurs, like an earthquake or hurricane. Payouts (the ‘then’) are pre-determined, based on objective data, for faster access to funds.
• Reduced costs: Overall risk management expenses are lower. Businesses can retain more of their traditional insurance and use the savings to fund a parametric solution, freeing up capital for other needs.
• Filling the gaps: Traditional insurance often falls short, especially for major ‘grey swan’ events (rare but predictable with significant impacts). This leaves a ‘protection gap’ where businesses are financially vulnerable. Parametric insurance fills this gap by providing extra financial resources (contingent capital), which is vital for immediate recovery after disasters like earthquakes.

Beyond natural disasters, this approach can also be applied to other unexpected events with measurable impacts, such as tourism slumps or cloud outages.

Conclusion

Parametric insurance paves the way for efficient climate risk management, providing crucial recovery capital as climate disasters worsen. By streamlining payouts and unlocking contingent capital, it empowers a proactive approach to catastrophic loss management. Further innovation and wider adoption of parametric solutions can play a crucial role in building resilience in a changing climate. Imagine a future where communities can bounce back faster, infrastructure is more robust and businesses have the resources to adapt. Parametric insurance offers a key piece of the puzzle for a more resilient tomorrow.

How can Infosys BPM help?

The insurance industry faces a changing landscape with rising climate risks. Infosys BPM's proven insurance practice, coupled with our understanding of parametric insurance solutions, can help you navigate this new reality. Our Insurance Outsourcing Services can streamline your operations, reduce costs, and ensure you have the right tools in place to thrive in this evolving climate.