Parametric Insurance – A Useful Tool for Fighting the Climate Emergency?
As the world faces the escalating impacts of climate change, innovative solutions are essential to manage the growing risks of extreme weather events. One such solution gaining traction is parametric insurance. This article explores what parametric insurance is and how it could play a role in combating the climate emergency or cushioning the financial impact of climate events. It also considers the regulatory landscape for such products in Singapore.
What is Parametric Insurance?
Parametric insurance provides payouts based on the occurrence of a predefined event, rather than the actual loss incurred. This is achieved by setting specific parameters - such as rainfall levels or wind speeds - that serve as indicators of potential damage. When these parameters are met or exceeded the insurance company will automatically pay out a predetermined sum to the policyholder or nominated payee. Importantly, the amount paid out is determined by the size or magnitude of the triggering event, not by the extent of the damage.
Readers based in Singapore may have come across parametric products if they have purchased certain flight delay policies. Purchasers of such policies automatically receive a payment as soon as flight tracking data confirms that their flight has been delayed beyond a certain threshold, without the need for the purchaser to submit any claim to the insurance company.
Parametric insurance relies heavily on accurate data collection and advanced modelling. The process begins by identifying the risks to be insured against and selecting an index that measures those risks. For example, a drought risk could be indexed to specific rainfall levels. The insurance policy is then structured around this index, with specific thresholds set to trigger payouts. The value of the payments will, of course, be negotiated by the insurer and the insured. However, the value of the payout will be pegged to the likely loss.
Examples of triggers may include the following:
For policies covering storm or hurricane losses: wind speed at/within a predefined geographical area
For policies insuring against hailstorm damage: hailstone size as recorded by local monitoring stations or interpolated from satellite images.
For policies insuring against yield loss at solar panel farms: cloud cover and density over a particular time period.
For policies insuring against loss of agricultural yield due to excess rain or drought: amount of rainfall as recorded by local monitoring stations
Advantages and Disadvantages of Parametric Insurance
Arguably, parametric insurance offers the following benefits compared with traditional indemnity-based insurance products.
Speed and Efficiency. Parametric products pay out based on pre-agreed event triggers and can provide liquidity immediately after an insured loss event. In contrast, traditional insurance typically pays out after a lengthy claims processes during which the extent of damage is investigated and the cost of restoration is considered.
Transparency and predictability. Since parametric products pay out based on objective data, the claims process is highly transparent. Further, because policyholders know in advance what conditions will trigger a payout and the amount they will receive, products allow for better financial planning.
Filling the insurance gap. In places where traditional insurance is either too costly or unavailable due to high risk, parametric insurance may be a more viable option. Its structure allows for coverage in scenarios where conventional insurance products might not be accessible. In principle, at least, any financial loss can be insured so long as there are available datasets of sufficient quality to describe the risk exposure.
That is not to say that parametric insurance has no limitations. The most significant limitation is that payouts are not based on actual losses, meaning they may not fully cover the damage incurred. The industry refers to situations where the parametric index does not perfectly correlate with the loss a “basis risk”. A negative basis risk means that there is under compensation because the loss suffered is more than projected whereas a positive basis risk is one where there is over-compensation because the loss is more than projected.
Additionally, the effectiveness of parametric insurance is dependent on the availability and quality of data as well as the accuracy of models. In areas where reliable data is scarce, implementing parametric insurance can be difficult. The recent announcement by the National Oceanic and Atmospheric Administration (NOAA) that it will not be updating its weather and climate disasters database also shows that insurers cannot depend on established data sets being around forever.
Real-World Applications
Parametric policies have already been implemented in various regions around the world at micro and macro level to provide cover for climate related risks as can be seen from the following examples:
The Caribbean Catastrophe Risk Insurance Facility (CCRIF), the world’s first multi-country risk pool, has for many years offered parametric insurance coverage to governments for tropical cyclones, earthquakes, and excess rainfall. 62% of all CCRIF payouts between 2007 and 2023 were for immediate post-event activities. CCRIF’s ability to provide quick payouts to member countries following natural disasters, has been praised for enabling faster recovery and reducing the need for international aid.
The Agriculture and Climate Risk Enterprise (ACRE) program in Kenya, Tanzania, and Rwanda provides smallholder farmers with parametric insurance against crop failure due to drought, excess rain and storms. When local solar-powered weather stations detect pre-agreed climate stress-events, compensation for yield loss of maize, sorghum, coffee, sunflower, wheat, cashew nuts, and potato crops is triggered immediately and paid via a mobile money transfer service.
In 2023 the African Risk Capacity (ARC) Group launched a customisable parametric flood insurance product for Madagascar, Mozambique, Malawi, Cote d’Ivoire, Ghana, and Togo. The product is based around daily flood analysis and calculation of associated impacts for each country. These impacts are compared to triggers such as economic loss or number of people affected and payouts are calculated if the impact of the floor exceeds the trigger threshold defined by the country.
Last year WTW and BHP unveiled a parametric insurance policy designed to help protect the coral reef ecosystems located around the Lau Group of islands around Fiji. The coral reefs in this location are under threat from ocean warming, acidification and the increasing frequency of tropical cyclones. The policy is structured to trigger payouts following stress events to fund rapid reef response activities (such as reattaching broken corals and cleaning up debris) and also to fund community assistance programmes which help alleviate food and water scarcity caused by storm damage.
Many of these policies are marketed to sovereigns or sub-sovereigns as well as disaster relief and humanitarian organisations.
The Legal status of Parametric Policies
Concerns have been raised about whether parametric policies are truly contracts of insurance or whether they are better classified as derivatives (a kind of investment product). Indeed, parametric policies are being marketed in some quarters as ways for investors to diversify their portfolios, access uncorrelated returns and align with client concerns about climate change.
If parametric policies are classified as derivatives, they will be subjected to different regulatory and supervisory overview than if they are classified as insurance products.
The concerns about the legal status of parametric policies typically resolve around the following two issues:
Insurable interest. As stated above, many policies are being marketed to entities which may not own or be in anyway responsible for the physical assets which is being insured. In the absence of such an insurable interest, the policy can be conceptualised as a contract of wager.
Absence of an indemnity. Because parametric products pay out based on predefined triggers rather than actual loss, they blur the line between insurance and a speculative bet.
These concerns have no conclusive answers in Singapore.
Singapore has no statutory definition of what constitutes a contract of insurance. In Eng Beng v Lo Kok Jong [2022] SGDC 130 the court applied the definition used in the old English case of Prudential Insurance Company v Inland Revenue Commissioners [1904] 2 KB 658 (“A contract of insurance... must be a contract for the payment of a sum of money, or for some corresponding benefit... to become due on the happening of an event, which event must have some amount of uncertainty about it, and must be of a character more or less adverse to the interest of the person effecting the insurance”). If tested, it appears likely that parametric policies would be capable of satisfying this definition.
Important consequences follow from parametric policies being classified as contracts of insurance.
Section 151(1) of the Insurance Act 1966 (“IA”) provides that “An insurance must not be made by any person on any event wherein the person for whose use or benefit or on whose account the policy is made has no interest, or by way of gaming or wagering; and every assurance made contrary to this subsection is void.”
Section 151(3) of the IA provides that “in all cases where there is an interest in such event, no greater sum may be recovered or received from the insurer than the amount or value of the interest.”
However, Section 151(4) of the IA provides a carve out for contracts of indemnity.
If a local court were to find that a parametric policy does provide an indemnity, then the likelihood is that the policy will be given effect by the courts as the Section 151(4) carve out would apply. Obviously, the court would have to interpret the word ‘indemnity’ broadly as the ordinary meaning of the word is compensate a party for the loss that is has incurred. The argument would be that the product model used by the parties was a genuine pre-estimate of the loss which was likely to flow from the loss event. Seen in this light, parametric policies are similar to valued policies, which have long been enforced by the court. By parity of reasoning with valued policies the court may give an expanse interpretation to the word ‘indemnity’.
If the court were to find that a parametric policy is not a contract of indemnity, then an insurable interest would need to be established. Failure to do so would put the policy at risk of being struck down as void, either under Section 151(1) of the IA or under Section 5 of the Civil Law Act (which voids gaming and wagering contracts). The court may take the view that an insurable interest can be satisfied by the insured showing that it has suffered an economic loss on the occurrence of the insured event. Here the court may follow English decisions which lean in favour of finding an insurable interest (see for example Quadra Commodities SA v XL Insurance Company SE [2023] Lloyd’s rep IR 488 at [122]) as English decisions are generally persuasive in Singapore. Depending on the unique facts of each case, arguments may be able to be made that the insureds have some ‘skin’ in any loss event because they either suffer the loss directly or have an exposure such as the need to assist in post even recovery or mitigation works. For example, an insured NGO may be obliged to go out and repair a damaged reef after a hurricane which would cause the NGO an economic loss.
Regardless of how the courts rationalise the legality of parametric policies, lawyers would undoubtedly play an important role in drafting policies, assessing suitability of models and in guiding the court. There is also a prospect of regulatory or statutory assistance: in November 2024 DPM Gan Kim Yong announced to attendees at the 20th Singapore International Reinsurance Conference that “MAS is studying ways to support the growth of parametric insurance”; and in 2020 Singapore’s SAL Law Reform Committee recommended basically removing the need for an insurable interest in non-life and indemnity policies.
The Future of Parametric Insurance in the Climate Emergency
Parametric insurance offers a promising solution to some of the challenges posed by climate risks. Its speed, efficiency, and transparency make it an attractive option for managing the financial impact of extreme weather events. Unlike traditional insurance products, which require lengthy claims processes, parametric insurance allows for rapid payouts triggered by predefined parameters, providing immediate relief when it is needed most. This immediate relief can be put to use to repairing natural assets whilst they can be repaired. The immediate relief can also help reduce human misery by providing cash to communities to see them through the economic fall-out (such as collapse in tourism) which often follows natural disasters.
As the climate emergency continues to intensify, the demand for alternative risk transfer (ART) solutions like parametric insurance is likely to grow significantly. This growth will be driven not only by an increased awareness of such products but also by advancements in data collection, satellite technology, and predictive modelling. These technological developments will enable parametric solutions to cover a broader range of risks, extending beyond traditional applications.
One can expect to see parametric elements being increasingly added into traditional indemnity-based policies. This hybrid approach will allow policyholders to access immediate liquidity following a natural catastrophe. This not only bridges the gap between initial loss and longer-term recovery, it will also enhance the resilience of individuals, businesses, and communities by providing liquidity when needed most.
The author, however, contends that for parametric insurance to reach its full potential, several key steps must be taken. First, there needs to be greater investment in data infrastructure, particularly in developing countries, to build reliable and accurate indexes. Second, stakeholders must work together to address basis risk and ensure that parametric insurance policies are designed to meet the specific needs of policyholders. Finally, efforts must be made to make parametric insurance more affordable and accessible, particularly for vulnerable communities that are most at risk from climate change. In this respect education is key as parametric insurance is presently a produced with only very shallow penetration into markets.
Given the benefits of parametric insurance, the author believes that there are strong reasons in favour of governments and/or regulators reviewing their laws to ensure that parametric policies are not unnecessarily rendered void for lack of insurable interest or because they do not provide a true indemnity.
Donald Spencer