Why parametric insurance could be a climate disaster aid solution in the Global South

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Thomas Johansmeyer, Global Head of Index Classes, Inver Re

• Natural disasters are becoming more frequent for the most vulnerable parts of the world, and limited access to relief only compounding their impact.
• Foreign aid has meanwhile become less reliable due to political volatility in donor states, which can further frustrate the flow of aid to where it’s needed.
• Here’s why parametric insurance and reinsurance could offer a fast and lower-cost solution and become a key part of the relief capital mix.

Natural disasters are becoming more frequent and severe and for the most vulnerable parts of the world, limited access to relief and recovery capital stands to compound the destructive effects of these climate events.

Political volatility in donor states has made foreign aid less reliable. Already negotiated from a position of weakness, the flow of aid could be further frustrated by unexpected political impediments, as we saw with the stalled US Congress in October 2023.

DISCOVER

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Although reliance on foreign aid as a form of relief capital won’t disappear, it’s becoming crucial for states in the Global South to diversify their sources. Parametric insurance and reinsurance – or “re/insurance” – could offer a fast and lower-cost solution and become an important part of the relief capital mix.

Unlike traditional insurance, parametric policies focus on the magnitude of a specific type of an event, with a simple, straightforward payout process. For example, a parametric policy could pay out when tropical cyclone winds reach a certain windspeed in Japan or an earthquake achieves a pre-negotiated magnitude in Istanbul. The same concept applies to reinsurance, which is often known as “insurance for insurance companies”.

While it would not replace aid, parametric re/insurance could deliver short-term relief capital while larger aid packages are negotiated.

Rising natural disaster risk for the Global South

The risk of increased natural disasters around the world is particularly menacing for the Global South. Analysis of natural disaster data from EM-DAT international disaster database shows that such events cost Asian states in the Global South alone more than $400 billion from 2014 through 2022.

The full scale of natural disaster economic impact across the Global South is thus massive, and it becomes even greater when security concerns adjacent to economic risk are contemplated. The interconnection of food, water, societal and human security via economic security underscores the importance of ensuring the flow of relief capital after a major natural disaster.

Unfortunately, preparing for future natural disasters requires balancing against near-term priorities. Particularly in regions where economic resources aren’t abundant, investments in resilience – including insurance – tend to take a back seat to initiatives with more immediate impact.

And this works when your disaster risk finance strategy is to rely on foreign aid. The problem is that relying on foreign aid is free – right up until you need it. Then, negotiations can take time and leave the affected state subject to the whims of public opinion in a donor state – not to mention bureaucratic impediments and even the improper function of government institutions.

If the reliance on foreign aid for support in the aftermath of natural catastrophes was a fraught strategy before vacated speakership in the US House of Representatives last October, then it can only be seen as perilous today.

For 22 days in October 2023, legislation was stalled due to a procedural member that left the Speaker of the House role vacant. The inability of the United States to respond to needs for financial support related to several conflicts illustrates the problems that would arise with regards to natural disaster aid, as well.

Political volatility and polarization in several western nations suggests that this risk is not isolated to the United States and could also arise in larger states around the world.

That episode demonstrates the nature of a risk that could be visited upon any source of donor capital or foreign aid. It’s conceivable that a donor state wanting to help may be constrained by its own bureaucratic machinery, leaving disaster aid out of reach for an undeterminable period of time.

The alternative offered by parametric insurance

Parametric re/insurance is naturally suited to the Global South. While traditional insurance typically requires historical data around penetration, premium, and losses, parametric re/insurance is free of these constraints.

All that matters is the likelihood that a given event of a given magnitude occurs. There’s no room for regulators to change the rules or the need for underwriters to evaluate protection buyers. Simplicity is what makes parametric re/insurance effective.

The mechanism is quite simple and is best explained with an example. Let’s say you want to insure a farm in Chile, and you want $10,000 in insurance protection for earthquakes of at least 7Mw on the moment magnitude scale.

You would pay premium for your parametric earthquake insurance policy, and if there’s a 7Mw earthquake during the policy period, you’d collect $10,000.

I recently helped several reinsurers provide protection in Türkiye to companies insuring risks in and around Istanbul, not to mention another reinsurer that specializes in parametric risks across Africa.

The mechanism isn’t just simple; it’s secure. Many re/insurers have expressed concerns about deploying capital to support states in the Global South because of issues such as political risk, corruption and moral hazard.

Because the trigger mechanism is based on event magnitude reported by a third party, such as the United States Geographical Survey (USGS), local market risks become much less relevant. Furthermore, the flow of capital is accelerated by the fact that the modeling required of re/insurers stays focused on the peril only – e.g., how likely a hurricane is to make landfall in the covered area.

Getting started with parametric re/insurance

Disaster risk financing will only become more important in the near future and beyond. Parametric re/insurance may seem like an imperfect alternative to foreign aid, but used properly, it can provide near-term relief when it’s needed most, enabling more time to negotiate for larger aid packages. Furthermore, it is becoming widely available.

Global reinsurers want to write more parametric re/insurance in the Global South. To access these deep worldwide capital sources, re/insurers across the Global South just need to ask. There’s a global market ready to get involved.