The Promise of Parametric Insurance (GS Paper 3, Social Security)
Context
- The year 2023 has been the warmest on record, causing $280 billion in losses from natural disasters, of which only $100 billion was insured.
- This insurance gap is more pronounced in developing countries, necessitating innovative insurance solutions like parametric insurance to enhance disaster resilience and financial protection.
Record-Breaking Year 2023
- Warmest Year: 2023 was the warmest year on record.
- Disaster Losses: Natural disasters caused $280 billion in losses, with only $100 billion insured.
- Insurance Gap: There is a significant gap in insurance coverage, especially between developed and developing economies.
- Increasing Extreme Events: With the rise in extreme weather events, the insurance industry must adopt new methods to enhance disaster resilience and coverage.
Current Methods of Disaster Risk Reduction
Indemnity-Based Insurance Products:
- Traditional Method: The globally accepted method for disaster risk reduction involves indemnity-based insurance products.
- Physical Assessment: These products require a physical assessment of damage to process payouts.
- Challenges: Given the unpredictability of future calamities, past precedents are no longer reliable. Verification of losses is particularly challenging for economically disadvantaged communities with little record of their assets.
Characteristics of Parametric Insurance
- Parameter-Based: Parametric insurance is based on specific parameters of a weather event, such as a certain amount of rainfall or specific flood levels.
- Real-Time Measurements: Payments are triggered by real-time measurements rather than actual loss verification.
- No Physical Assessment: Payments are made without the need for a physical damage assessment.
- Climate Adaptation: Disaster-prone island countries have adopted parametric insurance for climate adaptation, moving away from traditional risk retention models.
Benefits and Implementation
- Trust Building: Parametric insurance builds trust between states and insurers, leading to reasonable pricing and effective trigger-payout combinations.
- Historical Use: Historically, these products have been used for low-frequency, high-impact disasters like earthquakes and cyclones.
- Example: In 2023, Morocco received $275 million in parametric insurance after a 6.8 magnitude earthquake, facilitated by the World Bank.
- Adaptation for High-Frequency Events: Increasingly considered for high-frequency, low-impact disasters like landslides and heavy rainfall due to climate change.
Parametric Insurance in India
Early Adoption and Government Initiatives:
- Crop Insurance: One of the earliest uses in India was for crop insurance.
- Pradhan Mantri Fasal Bima Yojana: Based on verification of loss.
- Restructured Weather Based Crop Insurance Scheme: Uses threshold limits, eliminating the need for field verification.
- Private Insurance: Private insurance in India is increasingly offering parametric products customized for states, corporations, self-help groups, and micro-finance institutions.
State and Corporate Adoption:
- Nagaland: The first Indian state to purchase parametric insurance for extreme precipitation in 2021. The state has since tendered for an improved version with specific annual premiums, duration, and competitive bidding for lower threshold limits and maximized payouts.
- Data Utilization: Uses credible data from the India Meteorological Department for precise precipitation measurements.
Sector-Specific Implementations:
- Dairy Farmers: The Co-operative Milk Marketing Federation in Kerala has implemented parametric insurance for dairy farmers to cover lower milk yields due to heat stress in cattle.
- Daily Payouts: Non-profits and micro-finance institutions collaborate with private insurers to provide daily payouts to workers losing jobs due to excessive heat, based on pre-defined temperature and moisture triggers.
- Large Corporations: Initiate parametric products for cyclonic winds and high waves using data on wind speed, cyclone tracks, and storm surges.
Ensuring Effective Use of Parametric Products
Key Factors for Government Implementation:
- Precise Thresholds: Essential for effective parametric insurance.
- Monitoring Mechanisms: Proper monitoring is crucial.
- Experience Sharing: Governments should share experiences to incorporate lessons learned.
- Bidding Process: A mandatory bidding process is necessary for transparent price discovery.
- Payout Dissemination: There must be a widespread retail payout dissemination system.
- Premium Payment: Encouraging premium payment by households is crucial, though challenging for poorer populations.
Examples from Other Countries:
- Earthquake Insurance: Successful implementation of parametric insurance for earthquakes in New Zealand and Turkey, even among poorer populations.
Potential for India and South Asia:
- India's Unique Position: Well-placed for the use of parametric products due to its Aadhaar-based payment dissemination system.
- Regional Pooling: Regional pooling of risk has been successfully implemented by the Pacific and Caribbean Catastrophe Risk Insurance Companies.
- South Asia Collaboration: Given the region's vulnerability to climate change, India and its neighbors could consider collaborative risk pooling and parametric products.
Conclusion
- The increasing frequency of natural disasters and the existing gap in insurance coverage necessitate innovative approaches.
- Parametric insurance offers a viable solution for enhancing disaster resilience and financial protection.
- By leveraging credible data and adopting collaborative risk management strategies, India and other climate-vulnerable regions can mitigate the financial burden of natural disasters.
