ILS & parametric triggers could support forecast-based social action

Social protection and relief systems are increasingly looking to respond more rapidly to the impacts of weather or natural catastrophes, with forecast-based action an area of innovation being explored. But, for these systems to scale-up, financing is required, with which the ILS market and parametric triggers may be able to assist.

Social protection, disaster relief and resilience are all increasingly benefiting from support provided by insurance and reinsurance capital, some of which is increasingly sought via the insurance-linked securities (ILS) market through issuance of catastrophe bonds or transactions such as the recent Philippine catastrophe swap.

Parametric triggers are often integral to these efforts, providing a risk transfer mechanism that can respond to the exact conditions that could create the need for a response, with a transparent and rapid payout or distribution of cash readily available when a parametric contract is triggered.

Forecast-based social action is a relatively recent development, where social protection actions are taken based on forecasts of weather conditions, enabling action to be taken quickly to protect lives and livelihoods against impending bad weather.

With parametric triggers and ILS structures typically making their payouts after an event has occurred and its parameters been recorded or validated, forecast-based solutions would be different in that they would need to payout based on what is forecast to occur, rather than what has already occurred.

Experts at Climate Centre, a specialist reference centre of the International Federation of Red Cross and Red Crescent Societies (IFRC), explained in a recent paper that the majority of large-scale national social protection systems are responsive in nature, but do not focus on preventing and anticipating climate, weather and natural catastrophe related shocks.

However the experts urge for a fresh look to be taken at this, as integrating responsive social action structures and preparedness would mean, “social protection can support more effective resilience building at scale.”

The experts explain in the paper what they believe is required, “Linking a Forecast-based Financing mechanism to a social protection system to enable anticipatory actions based on forecast triggers and guaranteed funding ahead of a shock,” saying that such a system could, “Enhance scalability, timeliness, predictability and adequacy of social protection benefits.”

Taking action as early as possible not only enhances resilience but also means the response can be proactive, offering a way to also encourage self-resilience by providing communities with the means to protect themselves better and take affirmative action to an impending threat.

Such forecast-based action is being tested around the world as a way to get help to people more quickly and encourage resilience, but in order for such efforts to scale a financing mechanism is required and here the insurance, reinsurance and indeed insurance-linked securities (ILS) markets can play a valuable role.

Highlighting the importance of such protection systems, with respect to weather and climate, the writers say, “Scalable social protection systems can support climate risk management by focusing on risk mitigation and preparedness measures that increase the capacity of the system to anticipate shocks.”

But scaling requires mechanisms for financing and for channeling donor funding into these action-based responses to forecasts, in much the same way that this has been done with parametric insurance and catastrophe bonds for rapid distribution of relief funds, as seen in recent World Bank efforts.

In fact, the recent World Bank pandemic catastrophe bond is designed to pay-out fast in order to offer a quicker way to get relief funding into countries so as to make a real difference to the spread of an epidemic, by financing a faster emergency response using a parametric trigger and financing structure that can enable funds to flow rapidly once the trigger is breached.

This is still based on the reported impact and spread of a pandemic, so is not forecast based,  but the trigger has been designed so as to get the capital to the people who need it as quickly as possible so as to make the maximum difference.

Forecast-based financing for social protection systems is a different problem to solve, but the writers from Climate Centre have identified that the contingent nature of ILS and catastrophe bonds using parametric triggers could make them a suitable way to marshal large amounts of forecast-based finance within accepted financial market structures.

Examples such as providing vaccination and veterinary kits to Peruvian farmers on the basis of a five-day forecast of extreme cold are given, as well as the distribution of preparedness items to flood prone communities in Uganda on the back of a scientific forecast of a major flood risk.

Forecast-based parametric triggers could underpin financing mechanisms that both enable donors to mobilise their capital, but that also enable greater scale of these efforts through the leverage of new capital sources, such as reinsurance and ILS capacity.

Given these forecast-based triggers would be linked to weather and natural catastrophe event scientific forecast data, it is akin to taking on the risk of these events occurring, just that the payout would be made based on the forecast data reaching pre-defined trigger points, rather than the event data itself being used.

So the forecast becomes the event that causes a financial mechanism to be triggered and pay-out, supporting the financing needs of a much broader roll-out of forecast-based social protection and aid systems.

The Climate Centre writers explain the need for innovative financing mechanisms to be used, “While social protection programmes could potentially establish contingency funds or budget allocation from programme funds, additional sources of financing would be required. Existing global relief pooled funds, preparedness funds, as well as risk transfer instruments have also the potential to be sources of funding in the framework of FbF.”

This would be aligned with the social development goals (SDG’s) and the mission of InsuResilience and the Insurance Development Forum (IDF), in utilising risk transfer and insurance based protection structures to broaden protection, increase resilience and enable better recovery from climate, weather and disaster events.

It’s an intriguing idea, one which is likely to receive attention in the usual circles of the World Bank, UN and various agencies that use disaster risk financing to support sovereign and also local needs.

There have been a number of parametric insurance products which are forecast-based, as well as some weather risk management products that have triggered based on forecasts rather than actual event parameters.

One of the best examples is an El Nino forecast-based insurance product, which paid out before the disaster struck based on an index-based El Nino forecast variable, developed by GlobalAgRisk.

These products have been few and far between though, with insurance typically based on an event occurring rather than a forecast suggesting one might occur. There have been efforts to create hurricane insurance products based on forecasts, but storms can be fickle and forecasts inaccurate, which has made these products difficult to sell.

But in a social protection and relief concept, where donors may be financing premiums and what is required is the capacity to back a much larger roll-out of forecast-based action and intervention, the capital markets and reinsurance could find these instruments palatable.

Also as the forecasts become more accurate and reliable the ability to structure parametric triggers based on forecast parameters could become more widely accepted.

It’s an interesting concept and one which would fit neatly into the mandate of an insurance and reinsurance industry seeking to narrow and close protection gaps.

As part of a cascading set of risk transfer, relief and social protection solutions for the future, designed to respond to forecasts of events as well as actual events occurring, it seems likely that forecast-based financing will have a significant role to play and that there may be an opportunity for ILS and parametric triggers within that.