Prudent risk mitigation is essential to investment success. Today, and for years to come, owners and operators of infrastructure assets will have to grapple with multiple challenges posed by climate change.
Our Red Paper, Climate Change: Building Resilience in Infrastructure Assets, published earlier this year provided one perspective on how stewards of infrastructure assets could respond to climate change.
This note addresses another dimension — integrating parametric insurance into business planning. Leveraging the rapid development of data analytics capabilities and remote sensing technologies, the recent growth of parametric insurance products has given infrastructure asset owners the ability to transfer natural catastrophe and weather risks to the capital markets.
As the world’s weather becomes more unpredictable as well as less hospitable, parametric insurance is likely to come to the fore as an innovative risk mitigation tool for infrastructure owners. Thus far, parametric insurance has largely gained traction in Europe, but we expect it to quickly make ground in North America as well as Australia as infrastructure industry participants become more aware of its attributes.
A parametric insurance product is defined as an insurance contract where the payment is settled based on a pre-determined triggering parameter (e.g. excessive rainfall, drought, cyclone intensity, flood height, wind speed etc.).
This differs from traditional (indemnity) insurance as parametric payouts are not based on actual losses, but on factors highly correlated with actual losses. In order to structure a parametric product, the triggering event or condition must be objective, observable, easily measurable, independently verifiable and consistent over time.
Parametric insurance is ideal for relatively infrequent, but high-intensity losses associated with natural perils and weather-related risk where there is an insufficient history of losses captured as insurance-readable data.
Parametric insurance products were first used by the international aid community in the early 2000s to help impoverished nations savaged by severe droughts, tropical cyclones and earthquakes.
The objective behind the first generation of parametric products was to simplify the loss assessment process and deliver quicker payouts to support immediate recovery efforts. Since then, historically low reinsurance costs have incentivised insurance companies to underwrite new business and penetrate new markets. They are doing this by leveraging diagnostic tools and technologies to measure the likelihood of adverse natural events and devise payment models.
At the same time, the growth of data analytics and remote sensing technology has turned parametric insurance into a powerful weather risk mitigation tool. Large reinsurers, such as Swiss Re, Munich Re and insurance companies such as AXA, Allianz or Sompo International, have dedicated teams to craft bespoke parametric solutions for a wide range of clients ranging from governments to infrastructure asset owners.
Property insurance and business interruption (BI) insurance have traditionally been used to cover infrastructure assets. In the event of a natural catastrophe, such coverage would indemnify against losses from physical damage as well as the cost of business interruption caused by those physical damages.
However, holders of property and BI insurance are sometimes still exposed to financial losses caused by natural catastrophes that do not result in physical damages. Parametric insurance addresses this coverage gap, as bespoke solutions can be developed to provide coverage typically not available from traditional insurance arrangements.
Infrastructure assets owned by QIC, on behalf of our clients, currently have comprehensive insurance covering physical damages and losses associated with business interruption in the event of natural catastrophes. However, some assets have historically had small coverage gaps owing to the complexity of the risk-underwriting process. The simplicity of a parametric cover now makes it possible to insure against natural catastrophes for those assets.
Variable weather patterns can have a direct impact on the cash flow of infrastructure assets. Infrastructure owners have recently used parametric insurance products to transfer weather risk to insurers and thus reduce the volatility of cash flows.
While most of the parametric products to date have been deployed in Europe, they are quickly making their way into the American and Australian markets.
Infigen, an active participant in the Australian energy market recently entered into an agreement with Swiss Re to cover their 500MW+ wind farm portfolio against wind resource shortfall. Payments from Swiss Re to Infigen are based on the annual average of recorded wind speeds at the turbine locations.
In addition to the potential to lower cash flow volatility, appropriate implementation of parametric insurance may also lead to more favourable lending terms during the financing and refinancing of projects such as wind and solar farms.
Innovation is ceaseless. If nature abhors a vacuum, likewise human ingenuity overcomes product and service gaps. Parametric insurance emerged from a gap that long-standing insurance products were unable to fill. By transferring weather-related risks from the infrastructure industry to capital markets, it creates new revenue lines for the latter while de-risking the former.
In our view, the value of parametric insurance to the active management of infrastructure assets primarily lies in the ability to mitigate weather variability, as opposed to natural catastrophes. In the majority of cases, the insurance industry is already well equipped to mitigate the risk of natural catastrophes through the use of traditional comprehensive insurance packages.
The use of parametric insurance to mitigate weather variability is expected to grow materially in the next few years, with significant trapped value being released through risk transference.
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