Natural Catastrophes expose insurance shortfalls
A measured approach – protecting against climate risks with parametric insurance
In the last few years there has been a growing interest in parametric insurance to cover a range of risks. Policyholders in numerous sectors and industries have sought cover for different types of exposures, but the application of this form of alternative risk transfer solution has predominantly been in relation to weather-related risks.
Climate change and the protection gap: a global perspective
According to the Intergovernmental Panel on Climate Change (IPCC), an estimated 3.6 billion people now live in areas highly exposed to climate-related hazards. Data from worldwide organisations such as the United Nations suggest that floods, storms, wildfires, and heatwaves are becoming more common. According to the Emergency Events Database, there has been a record rise in natural disasters globally since the 1960s. On average, the world faces approximately 390 natural disasters annually, affecting 218 million people.
In the face of a changing climate, and the resultant increasing frequency and severity of natural disasters, insuring against climate risks is becoming more difficult. Data from Swiss Re revealed that economic losses from natural disaster events in 2024 totalled US$318 billion. Of this, US$137 billion in losses were insured – leaving 57% uninsured (US$181 billion). According to WTW’s Natural Catastrophe Review, the insurance protection gap for natural catastrophes is estimated to reach 60% this year.
A report by the IPCC positions parametric insurance as a potential game-changer in closing this protection gap and enhancing financial resilience. The World Economic Forum also notes: “Amid an increasingly volatile climate risk landscape and challenging underwriting conditions, insurers are increasingly turning to parametric insurance to fill protection gaps and protect vulnerable communities and economies from climate risks.”
Parametric solutions and businesses
The application of parametric insurance hasn’t only piqued the interest of global organisations, it is growing in popularity among businesses – including those in Australia.
In response to the rising number of natural disasters and the losses sustained, insurance cover against severe weather events including floods and cyclones has become more challenging in recent years, as insurers have reassessed their risk exposures and adjusted their offerings accordingly.
To help fill the gap in the market, parametric solutions have been developed.
Data shows the global parametric insurance industry generated US$17 billion in 2024 and is projected to rise to US$40.6 billion by 2033 – with 56% of the market share held by the natural catastrophe insurance segment. While the US is the largest parametric market, the Asia-Pacific market was forecast to grow by 18.3% in 2024, with Japan and Australia leading in adoption due to frequent natural disasters. Agriculture accounts for 34% of parametric insurance policies globally (parametric insurance was projected to cover US$6.2 billion worth of crops in 2024), while energy and construction are also key industries taking up policies.
How parametric insurance works
Traditional insurance is based on indemnity, whereby damaged assets are repaired or replaced, and the policyholder is indemnified for consequential losses incurred. Typically, a premium is paid in return for the promise to cover the actual loss incurred due to an incident or named peril. Payment is triggered by an actual loss or damage to a physical asset (for example, a fire causes physical damage to property and results in business interruption losses).
Parametric insurance does not indemnify pure loss but agrees to make payment upon the occurrence of a triggering event. Parametric, or index-based, solutions cover the probability of a pre-defined event happening instead of indemnifying actual loss incurred.
The structure of parametric insurance revolves around objective measurable data, known as ‘parameters’, which serve as an accurate and reliable measure of the extent of natural disasters and emerging risks. The event parameters or index are pre-determined. The covered events could be earthquakes, tropical cyclones, or floods where the parameter or index is the magnitude, wind speed or water depth respectively, notes Swiss Re. The key criteria for an index to be used as parametric insurance trigger is that:
- it is fortuitous, and
- it can be modelled.
For example, a policyholder could insure against a magnitude 7.0 earthquake or a category 5 tropical cyclone occurring in a defined geographical area. Other parameters could be flood waters reaching a specific level, rainfall exceeding a specific level, temperature fluctuations, the height of a coastal wave, and so on.
An example might be a farmer wanting to insure against drought as a lack of rainfall would result in a lower crop yield. They take out a policy setting the parameter that if rainfall in a specified region falls below 25cm during the prescribed period, the insurance will be triggered.
If the parameter or index threshold is reached or exceeded, the policyholder is eligible to collect payment. The event is measured by a reliable third-party source, such as weather stations or satellites or by an objective agent like a weather agency, a national earthquake control centre or similar. In the farmer example, the precise measurement of rainfall is provided by a trusted source, e.g. the Bureau of Meteorology, and if the threshold is reached (rainfall didn’t meet 25cm in the region during the period), the farmer will be paid out.
When a pre-defined threshold is reached, payouts are automatically triggered, regardless of whether any damage occurred as parametric insurance covers the probability of an event happening, not the actual loss incurred.
Setting the parameters: the role of science
An essential element in parametric insurance is the ‘measuring’ of parameters.
Swiss Re notes that a suitable parameter or index is any objective measure that is both reported by an independent third-party (neither the policyholder nor insurer) and correlated to the underlying hazard which can result in financial loss for the policyholder. “Any parameter or index that is used as the basis for a parametric solution must be objective, transparent, and readily available from an independent reporting agency.”
But there can be challenges in measuring the parameters – in terms of basis risk and accuracy of triggers.
“Basis risk occurs when there’s a mismatch between the coverage of the policy and the actual event that triggers payment, resulting in the policyholder receiving a lower payout than expected or no payout at all,” notes PwC. This can be driven by a number of factors, including the limited availability of high-quality data that accurately predicts the occurrence of an insured event, and/or the lack of an accurate and up-to-date index or trigger mechanism that accurately reflects the event.
“Reducing basis risk in parametric insurance typically involves improving the accuracy of models, refining index triggers, ensuring high-quality data and designing policies that align as closely as possible with the insured’s true risk profile.”
This is where science and technology come in.
Advancements in satellite technology, artificial intelligence (AI), and data analytics are strengthening the efficiency of parametric insurance.
Satellites permit (near) real-time visibility of a wide range of environmental conditions, across large areas and are being used to facilitate payouts for events like tropical cyclones using environmental proxies (e.g. wind speed) and demographic data, bypassing traditional post-disaster assessments.
Large datasets are being analysed to determine precise insurance parameters, improving reliability and accuracy, while IoT devices and remote sensors continuously track parameters, directly feeding data to systems. Insurers are able to use historical and current data to predict future risks and set trigger points, while large data sets from different sources like satellites and sensors can be processed and analysed to ensure all relevant information is considered. Meanwhile, algorithms learn from data patterns to improve parameter selection and forecast accuracy.
When it comes to climate change, while traditional insurance can struggle with the unpredictable nature and increasing frequency of extreme weather events, parametric insurance can be structured to anticipate these events using historical data and predictive models. Advanced technologies such as machine learning and big data analytics can be tapped to refine the parameters and thresholds to ensure greater accuracy and responsiveness. As an example, data from weather balloons or drones can be analysed in real-time to trigger insurance payouts automatically.
Incorporating satellite and radar technologies, machine learning and advanced physics into underwriting models has also enabled a more precise understanding of risks and a more granular approach to pricing to better incorporate the cost of climate change, notes Actuaries Digital.
Spotlight on: Parametric crop insurance
Given the popularity of parametric insurance in agriculture, there is scientific research focussing on this area, with several pilot programs worldwide testing new models to enhance coverage for different crops and climatic conditions.
Allied Market Research notes that an initiative in Ecuador is providing rice and maize farmers with a parametric weather index insurance solution to help mitigate the impact of climate-related losses by using precise weather data to determine payouts. The solution, developed through collaboration with local and international organisations, aims to safeguard smallholder farmers from climate-related risks by leveraging technology and satellite data.
Parametric crop insurance is an area being explored by the CSIRO.
Noting that parametric insurance can be developed to provide faster and more efficient assessment of losses, the CSIRO also acknowledges that insurance premiums are calculated based around the value of different parameters related to the risk and that the ‘parameter’ can be quite abstract.
The CSIRO explains: “A farmer is worried their crop’s yield might not produce enough income to cover planting costs. Or worried there might be a drought coming. They insure against these outcomes and receive a pay out if the weather is unfavourable and they don’t achieve the expected yields.
“As you can imagine, the numbers behind this can be complex. Beyond inputs such as water and fertiliser, insurers need to consider other factors to calculate an agricultural insurance premium. Variables such as crop varieties, soil type, local climate, and weather events all impact crop success. Data about these sorts of different variables already exists in platforms such as the Agricultural Production Systems sIMulator.”
By tapping into resources such as this, the CSIRO is using agricultural systems science to help model risks to farmers’ crops.
The science is underpinning new forms of insurance for farmers, including parametric covers that specifically target climate risks and/or management actions for farmers. The products are designed to help farmers better manage inputs to crops and protect their crops and income. The parametric solutions not only encourage smarter resource management but holds promise for environmental benefits.
The first product developed is designed to help manage risks associated with fertiliser management in sugarcane. “Sugarcane growers in north Queensland can insure their crops against low yield resulting from reduced nitrogen fertiliser applications. The benefit can be two-fold. Firstly, saving money by applying less nitrogen to their crop (while being protected if the crop doesn’t perform to expectations). And secondly, reducing nitrogen runoff onto the Great Barrier Reef as added environmental benefit,” notes the CSIRO.
Research and development are continuing as the CSIRO looks to expand the application of parametric insurance to other crops like wheat as part of the Drought Resilience Mission.
Future focus
With technology reducing basis risk and improving the accuracy of triggers, parametric insurance can provide coverage for policyholders in areas vulnerable to severe weather-related events and disasters. By leveraging science and technology, parametric insurance continues to evolve and address the coverage needs of policyholders facing climate change risk management challenges, including previously uninsurable climate risks.
Talk to your EBM Account Manager about how parametric solutions could form part of your insurance program.
