Parametric Insurance: An Important Tool for Climate Change Adaptation

Supriya Nigudkar, Business Development Lead at Agvesto, examines how parametric insurance policies can help farmers adapt to – and thrive in – a changing climate.

Climate change is one of the most pressing global challenges facing the world today. As the impacts of climate change get more severe throughout the world, it affects the livelihoods of farmers in various ways. But with changing times and an environment that is turning volatile, the agriculture industry is in dire need of methods and support to help it stay strong and secure.

It is not just developing countries that are worried about food security. The problem is universal.

Given the current context, it is vital to ensure resilient agri-food systems across the planet, and building resilience to disasters is key to climate change adaptation. In these efforts, parametric insurance is an important tool for climate adaptation, as it is strongly linked to disaster resilience in society.

Weathering a changing climate

Parametric insurance holds the potential to help bring farmers and the agriculture sector out of their current structural dependency to a self-sustaining and resilient industry. Also known as event-based insurance or index-based insurance, parametric insurance is mostly used to provide cover for natural disasters. It is a form of insurance that covers the probability of a predefined event happening, instead of indemnifying the actual loss incurred. (A pay-out amount in the case of the policy being triggered is determined in advance.)

What does this look like in practice? For instance, a policy can cover crops for a pre-determined sum per acre in case of loss or damage arising from unforeseen events. The perils – or covered causes ­­– can include aspects like droughts or rainfall deficits. That is, if crops are damaged or lost due to any pre-defined event, pay-out will occur. This way, farmers are getting assurance that their yields are protected.

Farmers get assurance through pay-out if crops are damaged or lost due to any pre-defined event, writes the author. Photo credit: Pexels

The events could include everything from earthquakes and cyclones to floods and droughts, where the parameter is the magnitude of the event. Natural catastrophes or weather events are the most prominent triggers for parametric insurance policies. But other possible triggers could be market indices, crop yields, and so on. This process eliminates fraudulent claims and the need to go through a claims settlement process. In turn, this reduces claim adjustment costs and creates a smooth, transparent, and stress-free experience.

Any parameter, or an index, is used as the basis for a parametric solution. This must be an objective metric (that is, independently verifiable), transparent, and consistent. It is recommended to look for indices that are easily measurable and captured quickly and effectively to ensure prompt pay out to farmers.

The policy determines a coverage trigger – when a pay-out will occur – that is often connected to an index linked to underlying financial loss. Once these parameters have been set, the reference index is monitored and once the specific triggers are met, the policy pays out.

Benefits of parametric insurance for farmers

Parametric insurance policies hold several potential benefits to farmers and insurance providers alike. First and foremost, these polices provide coverage for circumstances that were previously uninsurable. These policies therefore help in closing protection gaps for farmers and others in the global agri-food chain. Furthermore, the transparent and objective determination of the actual insurance pay-out provides certainty for the insured, who do not have to worry about justifying a claim. On top of this, there are no restrictions on how the pay-out is used. For the payer, this reduces the cost of claims settlement and underwriting, making them more flexible to meet customer needs.

Independent parties are crucial to provide information on pre-defined events, such as excessive rainfall or drought. Photo credit: Pexels

However, this process requires an additional key element. An independent, third-party source, providing the relevant information, is a crucial requirement for the parametric cover as the entire pay-out is based on this data. This removes any potential conflicts of interest and provides transparency to customers on the data used and the reliability of the product.

Parametric insurance has the potential to provide farmers with additional peace of mind as they do not need to take loans from private lenders at higher interest rates to cover potential crop damage. This, in turn, can help encourage farmers to adopt modern and innovative agriculture practices that further increase their personal income. In the end, it becomes a tool that can not only help protect farmers from the consequences of a changing climate, but also drive economic growth and innovation in our food systems.