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Oct. 28, 2020, 1:27 p.m. EDT

How the U.S. could be smarter about insuring against extreme weather-related disasters

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By Kathy Baughman McLeod

Monumental challenges are all around us: the COVID-19 pandemic, the masses of people in the streets demanding racial justice, and the increasingly painful afflictions of climate change. While the pandemic is constantly unfolding, and the protests are calling for a centuries-old reckoning, the impact of climate change is ever-present, and the underlying cause of a cascade of crises globally, from fiercer and more frequent storms, floods and heat waves, to swarms of locusts on three continents, to a growing population of climate refugees likely to be the largest movement of humans the world has ever seen.

None of these events occur in a bubble. They cannot be viewed discretely from one another; just as the pandemic has shown us how combating a virus and restarting an economy cannot be decoupled and addressed individually.

How will we even begin to tackle such monumental, complex challenges? There is, in fact, one industry that is particularly well-equipped to solve such large-scale problems. It represents $31 trillion in assets—roughly 43 times the annual U.S. Department of Defense budget—can move markets and reshape societies, and indeed has done so repeatedly, and is in the business of risk so is well-suited for these times. I’m speaking, of course, of insurance. 

We all use insurance to protect against possible harms that might befall us, our property, our family, our livelihoods. But insurance changes behavior on a large scale as well. In the late 19th and early 20th centuries, most urban environments were built primarily of wood and were, therefore, massive fire hazards. Indeed, conflagrations tore through some of the world’s most iconic cities: Chicago in 1871, Boston in 1872, San Francisco in 1906 after an earthquake, and Tokyo in 1923, also after a major quake.  

Overwhelmed by the number of claims, insurance companies soon found themselves losing money, so the industry began to demand that cities reduce their risks by upgrading their safety and prevention measures and infrastructure to qualify for coverage. Suddenly, cities began installing fire hydrants and fire stations, building houses with fire escapes, and mandating that homes and offices feature fire alarms. Building codes became much more stringent, and the number of major fires and fire-related deaths decreased dramatically. 

Parametric simply means that the insurance pays out after some pre-defined triggering event, usually pegged to some kind of quantifiable number (the “metric”), such as wind speed or ground shaking. The premium on a parametric varies dramatically based on the probability of an event occurring depending on a host of factors, such as geography.  A hurricane parametric might cost (plus or minus) 10% of the total coverage in Miami while an earthquake parametric in Seattle might cost (plus or minus) 3% of the total coverage amount.  The pricing of these products shouldn’t be compared apples-to-apples to the better-known indemnity insurance, which is priced on the vulnerability of assets to various risks and only covers the assets themselves.  While indemnity insurance plays a key role in managing financial risk, it doesn’t account for the ‘total cost of risk’ like parametric insurance does.  The probability of an event happening, high or low, dictates a high or low premium on a parametric. Think of the likelihood of a hurricane in Boston versus Miami — one is much more likely than the other.  

The universe of parametric insurance is vast. Film and television productions can take out a form of a parametric called disgrace insurance, triggered by a real, quantifiable and trademarked Public Outcry Score, in case one of the movie or TV show’s stars is suddenly embroiled in a scandal and throws the financial fate of the production into disarray. David Beckham took out a form of parametric insurance on his legs — his livelihood. Concert pianists often do the same for their hands. 

Expand this model outward, beyond an individual or business, into whole regions or nations, and you begin to see how parametric insurance might begin to solve for these large-scale problems. The metric, in many cases, might be an especially high temperature, or particularly large storm surge. Better still, the metric wouldn’t come after the event, but in the form of a prediction—a forecast. That way, the insurance payout comes in advance, and goes toward preparing for the potential disaster to come, reducing the extent of the overall damage. 

In this scenario, what if a parametric policy triggered a payout when a disaster of a certain strength was reliably predicted so people could evacuate to safety — even those without the financial means to do so on their own? The wildfires currently devastating some of California’s most vulnerable communities are a great example. Coverage purchased by a local or state government for residents in a certain ZIP Code, for example, could provide quick payment to a personal payment app, like Venmo, or a digital Visa or Mastercard good only for food, fuel, transport and a certain number of nights at a hotel. How many lives could we potentially save? And how much money could we save in public safety service costs? 

We could imagine a world where we are no longer always caught flat-footed and struggling to respond and recover, but actively getting in front of problems by constantly looking ahead. That might, in fact, be the greatest stumbling block for unleashing this transformative mode of financing and for more protection at all levels of society. It’s a simple failure of imagination. To insure something, that’s often all it takes. When Warren Buffett recently lamented the fact that he hadn’t taken out insurance on the airline companies facing financial catastrophe due to the pandemic, he wasn’t chiding insurers, but his own lack of foresight. We can see the risk and imagine the future, it’s only a matter of will and some research and number crunching to get there. While this insurance product is relatively new, with the first one in the late 1990s, it focuses on a bigger-than-consumer scale and is not yet mainstreamed. Our new higher and growing-risk world portends the parametric as a potentially ubiquitous approach to managing and transferring risk. 

In fact, a precursor to these policies is forecast-based financing — and it’s already here. There are programs using forecast-based financing in Bangladesh, the Dominican Republic, Haiti, Mozambique, Nepal, Peru, and the Philippines. In Bangladesh, the cash payouts triggered by cyclone forecasts fund evacuations, and have thus far saved thousands of lives. In Peru, the payouts have gone to train rural communities in response to flash floods, which are increasing with each rainy season. This same model could easily be applied as parametric insurance policies for cities and towns throughout the U.S. — and, indeed, the rest of the world — that face extreme heat, where the mere forecast of mercury-topping temperatures would trigger a quick insurance policy payout that would go toward mobilizing backup generators, rolling out cooling stations,  preparing medical facilities, and deploying an urban search and rescue unit to get the most at-risk people out of danger — and spare the loss of life we are seeing today — especially the growing losses we are not seeing. 

What makes parametric insurance especially powerful is that its metrics aren’t one-size-fits-all. A 100-degree F day in Mumbai, for example, is not the same rare event as it is in Siberia. But this forced localization is a feature, not a bug. By making the terms fit the community, the responses and financing will fit the community, too. By working this way, we get more powerful and effective solutions. Localized solution-building is particularly meaningful these days, when nationalism is on the rise and autocratic leaders are gaining power, and when global alliances and international cooperation is on the decline. 

This doesn’t mean, necessarily, that we’re all on our own. It does, however, mean that we should all come to know and own the risks we carry in this new and changing world. Owning our risks means we better understand how to reduce our risks, and when you’ve done that to your best ability – protecting ourselves by deploying insurance appropriately is next – for both physical and financial resilience.  In fact, the more insured a population becomes, the more its economy grows, according to a nine-year study across 20 countries that looked, specifically, at life insurance. One might imagine how the rise of parametric insurance products for households or small businesses, insuring them against heat waves or floods, might lift economies further. Such bottom-up, community-based solutions are, in fact, rapidly filling the gaps left by the decline of global systems and institutions. Parametric insurance is a model that perfectly meets this moment by tailoring its policies to the specificity of place. 

One such place is the drylands of Kenya, where a population of over 10 million people live and raise 70% of the country’s cattle. Like many arid regions, the drylands are getting even drier, and the vegetation the cattle depend on for grazing is fast disappearing. In response, a consortium of Kenyan insurers, backed by the global reinsurance industry, created the Kenyan Livestock Insurance Program and began offering insurance to cattle ranchers vulnerable to drought using both satellite technology and remote sensing devices to measure vegetation and water levels available to livestock. When the system determines that vegetation and moisture have dropped below a certain threshold, the ranchers automatically receive a payment to their cellphones, which they can use for feed, medicines, and water. The event, in this case, has happened, but the deadly damage to their herds hasn’t – nor has the stress of that loss to the farmer. 

There’s still time to save the animals and stabilize the farmers’ livelihoods. Since October of 2019, the program has covered farmers’ “almost losses” with more than $7 million in payouts to 32,000 farmers. The rural farmers buying these policies are often doing so through basic text exchanges on their devices that do not qualify as “smartphones”. You can quite easily imagine apps throughout the world that would help small-business owners and individuals navigate a changing environment rife with what we once perceived as one-in-a hundred-years natural disasters. But the most powerful form of parametric insurance is even more basic. It’s looking at the built-in defenses around us, from nature, and paying out to bolster these crucial services: everything from urban tree cover for cooling neighborhoods and absorbing pollution to improve air quality to mangroves, marshes and reefs for flood control and coastal storm protection. 

Beginning in 2015, I worked with a team of coral reef scientists and coastal resilience practitioners from The Nature Conservancy to develop a pilot project which would become the first-ever insurance of a natural asset, the Mesoamerican Reef, which was protecting the shoreline and hotels there, and helping slow beach erosion. Our modeling showed that if the reef lost a meter of coral, the increased wave power could result in damages to infrastructure totaling some $9 million. But, because the reef is there, intact and breaking the waves, the region avoids annual losses of some $1.8 million. The reef is a natural asset, providing a multitude of services, but the reef needed protecting, and coral pieces that break off during increasingly stronger storms required restoration after each storm, a labor-intensive task that costs money. We developed an insurance policy that, after a hurricane, quickly pays out to fund a rapid response to clean, repair and rebuild the reef and the beach, so that it can continue to do what it does: protect the vulnerable coastal communities and economies that depend on it. This 95-plus kilometer stretch of high-value reef is still insured today by a patchwork of businesses, universities, nonprofit organizations, and local governments. Each of these parties has a stake in protecting their coastal community and habitats. News of the first payout, triggered by Hurricane Delta — a Category 2 storm that made landfall October 8 in Quintana Roo, with wind speeds of 130 MPH — is expected to be announced imminently. 

My key partner in the reef project, Alex Kaplan – a former Swiss Re executive and an expert in parametric insurance who is now leading a wholesale insurance brokerage business focused on innovation–describes the power of parametric insurance best: as a confluence, where the full power of modern computing, data digitization, risk modeling and Artificial Intelligence all meet. A parametric is not just about risk, but future risk. It sucks in all of the data available to predict an event, which can include our behavioral data available from social media, and then gets out in front of it. 

Parametric insurance peers into the future and, in doing so, can prevent suffering, death, loss and destruction. It would be foolish to ignore such a flexible, powerful tool to help us fix our broken world.

Kathy Baughman McLeod is Director of the Adrienne Arsht-Rockefeller Foundation Resilience Center and SVP at the Atlantic Council.

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