Parametric Insurance for Climate Change Adaptation

Insurance can be an effective strategy to help cope with climate risks by pooling and sharing risks to avoid catastrophic losses, but it involves upfront costs. Conventional (damage-based) insurance reimburses a part of the actual damages from specific risks.  It requires a costly, time-consuming,  and conflict-prone claims adjustment process to value the actual damages. For the most part, conventional insurance is only available for formal-sector companies, public infrastructure, and relatively well-off households in low- and middle-income countries. With increasing climate change-associated risks, conventional insurance for these is likely to become increasingly unaffordable or inaccessible. Parametric insurance can help reduce insurance costs and supply gaps for utility-scale renewable energy, smallholder farming, and nature-based solutions for climate adaptation.

Parametric insurance pays policyholders fixed payouts that are specified in advance.  The payouts are tied to local weather or hydrological station data (triggers) and vary at different levels of the triggers. Typically, a maximum payout is specified to reduce insurer risks and premium costs for the buyer. The payouts are only intended to cover unusual levels of risk. Since parametric insurance does not require any claims adjustment process, the administrative costs are lower, and payments can be made more quickly.

Both conventional and parametric insurers typically buy reinsurance from larger companies, multinational or regional companies. Reinsurance reduces the covariate risks of offering coverage in a limited geographic area or sector that faces similar risks that are likely to occur simultaneously. 

Parametric Insurance for Renewable Energy (RE)

Hydropower, solar, and wind power are intermittent resources subject to daily, seasonal, and annual variability in electricity generation. High temperatures increase evaporation, and reservoir storage may be insufficient during major droughts. Additional capacity to reduce risks to hydropower is very costly. Conversely, flooding may increase reservoir sedimentation, reducing the effective storage capacity. Cloudy or rainy weather decreases solar flux for photovoltaic or concentrating solar systems.  Insufficient wind reduces power generation, and too much wind may damage turbines or require shutdowns.

This variability can cause major fluctuations in the amount and timing of electricity generated. Supply risks are particularly serious for independent power producers with long-term sales contracts with transmission and distribution utilities (Power Purchase Agreements). This reduces suppliers’ projected revenues (sales volume as well as seasonal or time-specific prices). It also may incur high penalties for failure to meet contracted supply (cash payments or a requirement to purchase power from other sources). It can also affect the ability to repay bank loans on time (defaults or late penalties) and reduce returns to equity investors. However, supply risks also affect utilities that generate their own power from large RE facilities that provide a large share of their total generation on a national or subnational distribution grid.

Parametric insurance can reduce the financial risks of unexpected cash flow problems jeopardising business viability. Since the typical revenue and payment period for utility-scale renewable energy facilities is one month, the ability to smooth out fluctuating revenues to cover costs is important, even if it involves an additional cost.

Parametric insurance pays policyholders a predefined, fixed amount of money when insufficient or excessive RE resource flows reach an agreed threshold documented in standard, local, standard records on rainfall, wind, or solar flux. Parametric insurance policies often specify various payment amounts associated with different levels of insufficient or excessive natural resource flows. Usually, the payouts only cover part of the actual losses.

Here is a hypothetical example of how parametric insurance works for a large-scale hydropower facility.  A one-year parametric insurance policy costs US$5,000,000. The watershed area has a six-month dry season with an average rainfall of 900 mm. The trigger level for an insurance payout is less than 750 mm of dry season rain. The insurance payout is US$100,000/mm of rain below the trigger level, with an exit level of no additional payout below 600 mm of rain. Annual hydropower sales are expected to be US$41.610 million with 750 mm of dry season rain, US$33.288 million at 720 mm, and US$8.322 million at 600 mm.

In this example, the insurance payout is US$15 million in a year with 600 mm of dry season rain or less, US$3 million with 720 mm, and US$0 with 750 mm. In a year with 720 mm of dry season rain, the hydropower facility has total revenues of US$36.288 million from sales and the insurance payout. That year, the insurance cost $5 million, but it only paid out US$3 million, so buying insurance turned out to be an unprofitable decision. However, in a year with 600 mm of dry season rain, the total revenues would only US$23.322 million, but the US$8.322 million insurance payout exceeded the insurance cost (making insurance a profitable decision). Since the RE supplier cannot predict the rainfall, it does not know whether buying insurance will be profitable or not.  However, it may still want insurance to reduce the uncertainty of potentially negative outcomes for the business.

Several transnational reinsurance companies (GCube, Munich Re, and Swiss Re) offer parametric insurance for large RE producers in low-, medium-, and upper-income countries, usually in partnership with domestic insurers.  Domestic insurers generally require an international partner to reduce correlated country risks.  Parametric insurance for RE generation is a customised product and typically has a minimum annual premium of US$100,000. Insurers reduce their exposure to climate change risks by limiting the policy term to one year and repricing the policy annually.

There are some market challenges to expanding parametric insurance. RE producers, domestic insurance companies, and insurance and energy regulators in low-income countries are often unfamiliar with the product.  Premium costs and uncertainty about the value of insurance are major constraints. In some areas, there may be insufficient hydrometeorological stations or remote sensing data to assess the climate risks.    RE suppliers may find it less costly to manage cash flow risks through reserve funds, credit lines, new loans, or renegotiation of existing loans than buying insurance. In particular, small-scale renewable suppliers may be less willing or able to buy this insurance. It might not be sufficiently profitable for insurance or reinsurance companies to offer these policies due to the transaction costs for customised products and the limited sales volume. There may also be legal barriers to entry for transnational insurance company participation and regulatory barriers for RE suppliers seeking to recover the insurance costs in rate approval decisions.

Nevertheless, banks should have some motivation for requiring RE borrowers to purchase parametric insurance or offering them incentives to reduce client loan repayment risks. Transaction costs can be reduced by allowing owners of multiple RE generation units to buy bundled coverage and incentivising RE industry associations to sell group policies to members.

Agricultural Microinsurance

Weather-indexed insurance can help crop or livestock farmers lower their risks of large income losses from unusual weather events. Insurers face high transaction costs in insuring small-scale farmers, especially in remote areas. Smallholder farmers in low-income countries may find weather-indexed insurance too costly at market rates.  Parametric insurance eliminates claims adjustment costs and reduces transaction costs. Development assistance organisations or governments often cover or subsidise some costs or risks. The transaction costs can also be reduced by working through governmental or nongovernmental (NGO) projects or cooperatives and farmer associations.

Some donor projects have allowed low-income farmers to pay previously agreed microinsurance premiums when they have available cash after crops are sold, 2) pay the costs in labour time, or 3) bundle insurance premiums with agricultural credit.  However, microinsurance might only be viable for private insurers with continuing development assistance organisation, government or NGO involvement, a concern in achieving scale and sustainability. Weather-indexed insurance may be a feasible add-on service for microfinance institutions or agricultural development banks. The effectiveness of weather-indexed insurance as a climate adaptation strategy can be increased by improving hydrometeorological data collection and information sharing to support farmer decisions (an approach implemented in Kenya). A Minimum Quality Standard (MQS) tool can estimate whether agricultural index insurance will benefit farmers and is the basis of a Quality Index Insurance Certification (QUIIC) system used in East and Southern Africa.

Parametric Insurance for Nature-Based Solutions

In Mexico, the Quintana Roo Coral Reef Insurance Vehicle provided parametric insurance for hurricane damage to coral reefs with payouts for reef rehabilitation. A Coastal Zone Management Trust (CZMT) Fund paid the insurance premiums with revenues from taxes paid by property owners benefiting from the reef.

Similarly, the Mesoamerican Reef (MAR) Insurance Programme supported post-hurricane coral reef restoration in four countries (Belize, Guatemala, Honduras, and Mexico) with premium support from an InsuResilience Solutions Fund.

Conservation International and the SwissRe Foundation piloted parametric insurance for mangrove restoration in the Philippines, funded by the sale of blue carbon credits and payments for environmental services from insurance companies benefiting from lower exposure to flood damage claims. The intermediaries plan to expand this approach to other Asian countries. 

Future Efforts

The InsuResilience Global Partnership set a vision of expanding the benefits of insurance and climate resilience to 150 million people by 2025. However, future efforts may be hindered by bilateral and multilateral aid cutbacks, which will increase the importance of private sector initiatives of insurers and financial institutions.

The Insurance Development Forum has an Inclusive Insurance Working Group promoting country diagnosis and market assessment, enabling environment reforms, advocacy, development of scalable products, evidence building and knowledge sharing, and a global platform of insurers and development assistance organisations. 

Eric L. Hyman was an Environmental Economist with the USAID.