Addressing loss and damage through Parametric Insurance Schemes

We know that climate change causes more extreme weather – such as longer and more frequent droughts and more powerful hurricanes – and we know that this creates
havoc in the societies affected.

Risk pooling is amongst the measures that have been pointed to as a way of warding off the consequences of climate change. Indeed, the Paris Agreement, in Article 8 on ‘loss and damage’, expressly points to ‘[r]isk insurance facilities, climate risk pooling and other insurance solutions’ as one of the areas where the parties to the Agreement should cooperate with respect to loss and damage associated with the adverse effects of
climate change.

When it comes to natural hazards such as droughts and hurricanes, the rationale
behind an insurance risk pool is that it can capitalise on the natural diversification of the hazard risks across a large geographic area. This allows the risk pool members to respond to certain, but unpredictable, risks while managing their risk as a group in a financially efficient manner. In other words, the risk pool enables its members to lower the costs of responding to the hazards covered by the pool.

When it comes to addressing the consequences of natural hazards in the Global South it is important that those affected receive compensation very swiftly so as to be able to provide a first response until humanitarian assistance arrives – and normal insurance typically has an appreciable leadtime from the damage occurs until the insurance amount is paid out. This challenge has been addressed by the three existing Global South multi-country insurance schemes (the Caribbean Catastrophe Risk Insurance Facility (CCRIF), the African Risk Capacity (ARC) and the Pacific Catastrophe Risk Insurance Pilot (now the PCRAFI Facility)) through the use of so-called ‘parametric insurance’. Whereas normal insurance is based upon an assessment of the actual post-event losses, pay-outs under these three schemes are instead triggered by certain pre-defined parameters being met. For example, the insurance agreement may stipulate that a hurricane of a certain magnitude hitting one or more of a number of predetermined cities triggers the payment of a defined sum. The predefined event(s) (the hurricane) is correlated to a parameter or to an index of parameters (e.g. the magnitude of the event and the cities hit). The use of pre-defined parameters means that when an insurance event occurs, it is possible to quickly and objectively establish whether the conditions for payment have been fulfilled and, if they have, to establish the size of payments due. In other words, payment can be made very swiftly as compared to traditional insurance schemes which must await the evaluative process of calculating actual losses. Parametric insurance allows those hit to receive the insurance payment almost immediately – so enabling them to quickly address the consequences of the natural hazard.

However, there is also an important weakness to parametric insurance: the parametric insurance coverage is modelled against expected consequences (economic ‘losses’ or ‘response costs’) of a specific hazard, so if the chosen parameters do not duly reflect the actual post-hazard consequences, the pay-outs may not match actual losses/response costs. Experience from the three operating Global South schemes has shown that parametric insurance schemes require very careful design and that in practice they only provide interim coverage between the time when a natural hazard occurs and when humanitarian aid arrives.

Another weakness of insurance as a way of addressing climate change loss and damage is that the schemes are costly. Indeed, not only do the Global South countries, as a rule, lack the resources to cover these costs, they also do not bear responsibility for the climate changes causing the more extreme weather. It is therefore not surprising that the three existing Global South multi-country insurance schemes have all been established with appreciable donor assistance.

Despite these important weaknesses, parametric insurance schemes may constitute a useful means to provide first-response-relief in the Global South to those who are
directly hit by natural hazards. Parametric insurance does not constitute a miracle solution, but when it comes to addressing climate change ‘loss and damage’ it does offer an extra ‘string to the bow’.

Read the full article

Morten Broberg is professor at the Centre for International Law and Governance at the University of Copenhagen.

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