Index Insurance’s Potential for Increasing Climate Change Resilience and How Actuaries Can Contribute
By Syed Danish Ali
Actuary of the Future, January 2022
Actuaries can play an active role in social impact by helping vulnerable communities access otherwise inaccessible insurance that can help increase their climate change resilience and improving their living conditions by lowering the risks that they face. Very simply speaking, index or parametric insurance is based on a selected index like earthquake magnitude, level of rainfall, yield index and various other indices and once these triggers are triggered, the insurance payout is paid immediately without long duration and costly claims assessment processes. The aim is to provide quick liquidity in times of catastrophes to keep the wheels of governments running and financing during the most crucial times, which are within 72 hours following a catastrophe. Of course, there can be partial payments too, in order to reduce basis risk, which is very simply the mismatch between what the customer would face losing and the compensation that she would receive. Not every insurance should be index, as index is launched in small and undeveloped areas where: 1) the infrastructure to provide indemnity insurance does not exist in the first place; 2) where the natural catastrophe risks are too high, such as island countries in the “Ring of Fire,” and 3) where providing indemnity would prove too inaccessible due to high premiums and so on. Hence, index insurance exists to create previously uncharted markets and the intention behind the indices, in most cases, is still to provide insurance and not to act as a derivative for hedge funds or catastrophe bonds.
Collaboration is key since there are many stakeholders and cross-specialties involved in making any index product a success. An actuary cannot become a meteorologist/geologist/macroeconomist/agriculture sciences expert in order to understand those alien terms, but a basic level of understanding and how things move in a data-driven analytical mindset is key. It is also exciting to know something about so many fields, and, over time, people can bring about much needed career satisfaction because launching any index product needs looking at from 10 different combinations in order to solve the problems. Over-specialization does not lead to low career satisfaction. Of course, the challenges are large, too, such as collaborating with so many government and international agencies, farmers, research and development companies, basis risk being high, product was viable in pilot, but failed when actually launched, in production, and so on. Despite these challenges, staying long and hard with the problems is a key step in learning in our careers and the deferred gratification that we can receive after hard fought wins.
So far, very few insurers opt for index insurance and actuaries working in international agencies are those with access to the best platforms in order to make the governments understand and implement the products and regulations. But hopefully, as climate change becomes more and more prominent, it will become part of the agenda for even the most far-behind-the-curve legacy insurers and there will be pressure to make index products, or combinations of index and indemnity. The creative first principles of index also mean the innovation path is wide open based on science and insurers don’t need to only copy the products made elsewhere. Here are a few real-life examples for how such products operate practically:
- Tourism index: Countries where tourism is a major source of earning have suffered from COVID19 considerably. Hence, the index on the average number of tourists can be made so that if this reduces beyond the trigger, income replacement payouts can be made.
- Mongolia livestock insurance for extreme winters:[1]: For example, Mongolia faces a unique risk of extreme winter “dzud” events that kill their livestock. In a landlocked country with very little vegetation due to permafrost, people depend on livestock for pretty much everything and it forms the majority part of their diet as well. After millions of livestock deaths in 2001-2 due to consecutive dzuds, the Mongolian government formed partial payments layered in three triggers with the third trigger acting as a cat event where the government acts as a stop-loss reinsurer (international reinsurance is also very limited in areas where index insurance is given).
- El Niño forecast insurance Peru: El Niño is a recurrent threat in Northern Peru that can bring catastrophic rainfall and flooding. Pacific Sea Surface Temperatures (SST) are determined as they are highly predictive and correlated with catastrophic El Niño events. Hence, based on this forecast, SSTs can signal a severe El Niño months in advance of its impact on land, enabling an insurance payment to be made several months before the onset of catastrophic weather. The advance payment can then be used for risk mitigation and adaptation strategies to reduce losses and disruptions from the impending disaster. The original product was designed to transfer the portfolio risks of rural lenders and thereby improve access to credit for smallholder farmers. However, since catastrophic flooding results in widespread damages and losses, Extreme El Niño Insurance Product (EENIP) could benefit other affected sectors that are not directly linked to agriculture.[2]
- Swiss Re coral reef index insurance against hurricane: Swiss Re teamed up with The Nature Conservancy and regional governments in Mexico to help protect the Mesoamerican coral reef off the coast of Mexico's Yucatan Peninsula. Research had shown that there was a connection between a healthy coral reef and the region's ability to sustain itself economically. In other words, if the reef were to die as a result of pollution and storm damage, it would no longer be able to prevent beach erosion, which, in turn, would threaten the region's key source of income, tourism. An insurance solution was derived that would ensure rapid disbursement of funds to enable trained community members to deal with reef damage following a severe storm. It was the world's first ever nature-based solution to protect Mexico’s coral reef.[3]
- Haze insurance for bad smog winter days in Singapore made by Swiss Re with the Singapore government.[4]
- CCRIF pays Haiti USD40 million as part of earthquake index insurance. For the 7.2 magnitude earthquake that hit Aug. 14, 2021, payment was made within 14 days.[5]
Getting involved in index insurance can thus make an actuary feel like a quantitative social policy advisor and development professional. Actuaries can act as a go-to resource for data-driven decision making. For example, an actuary can point out that due to micro-climates, one region has a lower risk and so should pay a lower premium than the other premium, even though from a policy basis, the preference is for one uniform rate. Because, for example, an area with higher rain also means generally richer farmers and the other area can have lower rainfall and, therefore, generally poorer farmers. If both pay the same price, despite the poorer region having the lower risk, that means that premium is not equitable because the poorer farmers are cross-subsidizing richer farmers. Actuaries can also contribute toward minimizing basis risk, sustainable pricing, data driven actual experience feedback, implementing IFRS17 for index insurance, and so on.
As this area is constantly evolving and is still in an emerging stage, actuaries can play a key role as the train has not left the station. Aside from traditional index insurance work, there is continuous innovation being introduced as well, such as satellite monitoring of crops, drones to assess damage on the ground, blockchain for automatic payouts, mobile as saving platform, etc.
Besides the social impact, varied work, and potential for innovation, another possible advantage can be extensive travel. For example, an actuary working today in index insurance for international agencies might visit 95 countries in 35 years of her career. This builds upon the millennial’s pre-existing attitude of being a global citizen and a digital nomad who knows multiple languages and cultures.
To conclude, it is hoped that this article is able to shed light on how actuaries can aid in index insurance markets development throughout the world and satisfy their career goals along with it.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.
Syed Danish Ali is deputy manager, Actuarial at PKF Al Bassam & Co. He can be reached at sd.ali90@ymail.com.