Will climate change find a solution in parametric insurance?

2021 has been pummelled by multiple natural disasters that reflect the impact of climate change, which is currently a scientific certainty and has become a top priority for nations and organizations.

Precisely 16 years ago, Hurricane Katrina swept through New Orleans bringing unprecedented levels of destruction and causing approximately 1,800 deaths. Now Hurricane Ida, the fifth largest storm to ever hit American soil, has once again poured chaos and destruction upon the land as it reached New Orleans as a category 4 storm (4 on a sale of 5), with winds up to 250 KMH, causing damage in the order of 30 billion dollars. Ida siphoned up so much water from the Gulf of Mexico that the Mississippi reversed course, flowing back from the delta to the source.

Only a few weeks ago Central and Western Europe witnessed floods with the greatest economic impact ever recorded on European soil with costs over 7 billion Euros, comparable only to the great floods of 2002 and 2013. However, if in 2002 and 2013 the overflow of major rivers did substantially contribute to the damage, the floods of 2021 came in bigger, faster waves from rivers and tributaries of smaller size, which led to considerable structural damage and, unfortunately, an exceptionally high casualty count. Let us not forget that these floods happened in highly climate-resilient places that were theoretically ready to face them.

We’re seeing clear evidence of increased severity in catastrophic events like hurricanes or cyclones but also the exponential increase in frequency and severity in secondary risk such as heatwaves, floods from heavy rainfall or forest fires. These so-called secondary risks will, as climate change piles on more impact and risk concentrates (with more people migrating to urban centres), impact societies and organizations more adversely.

In fact, if today we possess advanced knowledge and a wealth of data on catastrophic events which allow us to model risk with high accuracy, one cannot say the same of secondary risk. Alongside growing impacts we see diminishing underwriting capability, premiums and other costs going up, and even the disappearance of coverage from areas deemed high exposure. In parallel, the coverage gap widens. Such is the case in Germany, where about 40% of property policies in areas affected by flooding did not include flood coverage.

This sets the stage for a new kind of insurance, originally incepted in the 1990s, to come to the fore and go massive. Parametric Insurance.

Parametric Insurance breaks with dogma associated with so-called traditional insurance. For starters, they do not insure material damage, but events in themselves, climate-related or otherwise.

There is no insured capital but an indemnity cap, plus a pre-established index or parameter. When this index is reached coverage is activated and leads to compensation. All this without the need for traditional expert assessment or material damage having to occur. Pay-outs are thus expedited, happening within 2 weeks to 2 months, and therefore contribute to faster recovery and rebuilding. 

Currently numerous examples exist of practical applications for this kind of insurance in association with climate change. From hailstorms, which impact the agricultural sector and solar energy production, to excess rainfall and its harm to agriculture and transportation; from forest fires, which hinder lumber and paper production, to drought and how it impacts the wine-making or energy sectors; and so many others. 

It has become increasingly common to look to parametric insurance for coverage of any and all situations leading to financial loss as long as such loss can be directly correlated with one or more easily observable parameters.