Mitigating infrastructure risk with parametric insurance

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.


Defining parametric insurance and pinpointing its innovative features

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.

Example: In 2003, the World Bank worked with global reinsurers to cover the government of Malawi against drought. In that scenario, the government would receive payments from insurers if the seasonal amount of rainfall collected at weather stations was under a pre-determined level.

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.


Parametric insurance in infrastructure: Mitigating natural catastrophe risks

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.

Example: An owner of an open-pit salt mine in northern Australia was required to evacuate the site in the probable event of a cyclone, in accordance with health and safety obligations. Furthermore, following a cyclone and excessive rainfall, the owner must undertake costly and time-consuming geotechnical studies before operations can resume.

Lenders for the project became aware of the situation and realised that such events could prove costly and lead to significant delays. To address the problem, global reinsurer, Swiss Re offered a parametric product, which would pay out in the event of a tropical strength cyclone. The payout would be triggered if the cyclone is within 100 kilometres of the mine, corresponding to the same threshold applied to health and safety obligations.

Other similar examples include hurricane-related insurance for a power distribution/transmission network in Florida as well as tropical cyclone cover for an airport in the Philippines.

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.


Parametric insurance in infrastructure: Mitigating weather variability risks

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.

Example: An airport in the north-east of the United States has been subject to highly variable costs and operational disruptions associated with snow removal. Sompo International, a global insurer with specialised parametric insurance practice, has recently structured a policy that makes payment based on the inches of snowfall per snowstorm.

Wind farm owners have also used similar products to insurance against wind insufficiency risks. A report from GCube Renewables published earlier this year indicates that “across 430GW of global installed onshore and offshore wind capacity, GCube estimates that there is an unrealised value of US$56 billion due to a failure to efficiently transfer weather risk.”

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.


The rise and rise of parametric insurance

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.

We are actively researching and leveraging such innovative risk mitigation tools to protect and create value in the infrastructure assets we manage for our clients.

IMPORTANT INFORMATION

QIC Limited ACN 130 539 123 (“QIC”) is a wholesale funds manager and its products and services are not directly available to, and this document may not be provided to any, retail clients. QIC is a company government owned corporation constituted under the Queensland Investment Corporation Act 1991 (Qld). QIC is regulated by State Government legislation pertaining to government owned corporations in addition to the Corporations Act 2001 (Cth) (“Corporations Act”). QIC does not hold an Australian financial services (“AFS”) licence and certain provisions (including the financial product disclosure provisions) of the Corporations Act do not apply to QIC. QIC Private Capital Pty Ltd (“QPC”), a wholly owned subsidiary of QIC, has been issued with an AFS licence and other wholly owned subsidiaries of QIC are authorised representatives of QPC. QIC’s subsidiaries are required to comply with the Corporations Act. QIC also has wholly owned subsidiaries authorised, registered or licensed by the United Kingdom Financial Conduct Authority (“FCA”), the United States Securities and Exchange Commission (“SEC”) and the Korean Financial Services Commission.

For more information about QIC, our approach, clients and regulatory framework, please refer to our website www.qic.com or contact us directly.

This information is being given solely for general information purposes. This information does not constitute financial product advice and you should seek advice before relying on it. This information may be based on information and research published by others. No QIC Party has confirmed, and QIC does not warrant, the accuracy or completeness of such statements.

The Information may include statements and estimates in relation to future matters, many of which will be based on subjective judgements or proprietary internal modelling. No representation is made that such statements or estimates will prove correct. The reader should be aware that such Information is predictive in character and may be affected by inaccurate assumptions and/or by known or unknown risks and uncertainties. Forecast results may differ materially from results ultimately achieved. Past performance is not a reliable indicator of future performance.

Copyright QIC Limited, Australia. All rights are reserved. Do not copy, disseminate or use, except in accordance with the prior written consent of QIC.

All figures are in Australian dollars unless otherwise stated.


About QIC

Investment Capabilities

Knowledge Centre

Latest News

About QIC