Climate Risk and Parametric Insurance

Image source: Chanakya Forum

Climate risk is ubiquitous. Regardless of age, gender, and location, every country, government, community, company, and individual will be exposed to some sort of risk from the global catastrophe—climate change. In fact, many are already experiencing climate risks. Granted, the level of climate risk exposure is not homogenous—some communities suffer disproportionate exposure to climate risks due to their lack of social, economic, and political power. It is nevertheless undeniable that climate change affects everyone in some way or another, albeit unequally. 

As the intensities and frequencies of extreme weather events increase, the management and mitigation costs are also skyrocketing. Given that the cost of property insurance is rising steadily, investors are beginning to urge firms to disclose their climate risks, and governments are shouldering greater responsibilities for the social, economic, and environmental costs arising from climate catastrophes. Climate change is no longer just an environmental or social issue, but also an economic one. Global natural catastrophe losses have spiked in recent years. Considering all that is at stake, risk management is incredibly important to protect ourselves from climate change and its effects.

Source: Swiss Re

Singapore has made remarkable progress in its pursuit of sustainable development. However, as climate change continues to intensify, it poses unprecedented challenges to this low-lying nation. Recognising the urgency of the situation, Singapore has adopted a comprehensive approach to managing its climate risks, which includes the implementation of robust policies, investments in innovative solutions, and the cultivation of international cooperation. 

As Singapore expands its business activities in the international arena and continues to attract foreign investments, it is paramount for climate risk to be taken into account. This is where parametric insurance comes in handy. 

Parametric Insurance

Parametric insurance offers a unique approach that addresses the financial impacts of climate-related events. It is a type of insurance plan that pays out a predetermined amount based on the occurrence of a specific event, rather than indemnifying the actual losses incurred. What is special about parametric insurance is that it does not require any proof of physical damage to receive a claim payment. In fact, as long as there is a non-damage business interruption that leads to financial loss due to the occurrence of a particular event (e.g., an earthquake or a flood), then businesses can make financial claims under parametric insurance.

While parametric insurance may sound new to many, it has been quite popular in the agricultural industry in the form of crop and farm insurance. What is new, however, is the growth of new indices and parameters for risk assessment thanks to more advanced technologies and more comprehensive datasets. Thanks to advanced data and modelling systems, parametric insurance mitigates risk by handling it in a more proactive—instead of reactive—manner. 

Source: Federal Reserve Bank of Minneapolis

The agricultural industry is arguably most easily affected by a changing climate, as crop yields directly depend on certain climatic conditions. By possessing crop insurance, not only would crop yields be protected but investments made by farmers would also be insulated from disasters. As a result, farmers would be more willing to purchase efficient agricultural inputs and farming technologies. That said, parametric insurance is not restricted to the agricultural or farming industries. In a world that is increasingly suffering from the unpredictable effects of climate change, parametric insurance will gain relevance across all industries. After all, no industry is immune to climate change.

An Opportunity

The rise of parametric insurance has some implications. For one, parametric insurance serves as a business opportunity for companies that dabble in insurance and risk management. As parametric insurance continues to gain popularity, more (re)insurance companies would be willing to underwrite a variety of climate risks, providing greater options at a lower cost to clients. It could also be part of a strategy for building climate resilience for organisations—including governments.

Indeed, parametric insurance can be Singapore’s strategy for climate resilience. While Singapore is blessed not to have experienced natural disasters directly, it does not mean that the city-state will not be affected by them. After all, Singapore’s geographic location exposes it to significant climate risk in the form of rising sea levels. At the time of writing, SingLife is the first insurer in Singapore that offers parametric insurance in the realm of travelling. So if you’re afraid of getting your travelling plans thwarted by unpredictable rainfall or heat waves, you now know which insurance plan to buy.

Regionally, Southeast Asia is susceptible to a gamut of natural disasters such as volcano eruptions, earthquakes, typhoons, monsoons, and floods. Indeed, Singapore’s neighbouring countries, which are also its trading partners, including Indonesia, the Philippines, and Japan are plagued by many climate risks. This means that should any of these countries suffer from the aftermath of a natural disaster, Singapore would not be spared from the repercussions. Given Singapore’s strong economic and trading ties with its neighbouring countries, its businesses would take a hit and experience disruptions during unforeseen disasters. Therefore, Singapore’s open economy renders it equally vulnerable to climate change (whether it be natural or man-made) and its effects. 

Besides mitigating risk, parametric insurance can double as an adaptation strategy. Governments and businesses operating in areas disproportionately exposed to climate risk should consider parametric insurance as it provides financial aid, accelerating the recovery rate during disasters. Under traditional insurance schemes, claims would only be paid if those affected by disasters suffer a physical loss. The losses would have to be assessed and approved before claims are paid out, which lengthens the recovery process and produces uncertainty with regard to the amount claimable. This can be detrimental to those with limited financial capacity to cope with both material and non-material damages resulting from climate change. Parametric insurance, on the other hand, does away with the claims assessment process. As long as pre-specified conditions (i.e., triggers) are met, claims can be paid immediately, which expedites payouts. Some examples of a triggering event could be an earthquake, flood, power outage, and/or crop yield. 

While parametric insurance is more efficient and convenient than traditional insurance products, they should still be pursued in tandem as complements—parametric insurance should not serve as a substitute for traditional insurance products.  As parametric insurance relies primarily on pre-specified conditions, the insured may not be able to receive any compensation if a particular condition is not met. This spells disaster for the insured, not least since damages can result from a confluence of factors. Climate change can disrupt business operations in a multitude of ways. For instance, just because rainfall levels did not exceed a particular threshold would not make damages less severe, especially if high wind speeds also contributed to the damage.

But Not the Silver Bullet

Nevertheless, it is important to note that premium prices for parametric insurance will increase due to the prevalence and natural catastrophes induced by climate change since more claims will likely be made in the years to come. However, as insurance operates under the law of large numbers, if parametric insurance becomes more popular among business owners, homeowners, and governments, then premium prices would remain affordable thanks to risk-pooling.

With all that has been said, parametric insurance is only one means towards climate resilience and one aspect of risk management. It predominantly handles financial risk and seeks to provide financial compensation to the insured. The exact loss and damages incurred from a disaster may not always be accurately quantifiable. Moreover, parametric insurance may not address the long-term and often unnoticeable impacts of climate change such as gradual changes in weather patterns or shifts in climatic conditions. These slow changes may not trigger the predefined parameters for payouts, leaving communities exposed to chronic climate risks.

Ultimately, focusing solely on financial risk is inadequate for climate risk management because climate change poses multifaceted challenges that extend beyond economic losses, such as the degradation of ecosystems and human health. Therefore, it is imperative to combine parametric insurance with other risk management and resilience-building measures so that communities can better prepare for the unpredictable impacts of climate change.