More frequent wildfires could drive up the cost of insurance for vulnerable businesses

The world is getting warmer and drier, making the occurrence of wildfires more frequent. According to the Insurance Information Institute, the annual number of acres burned in wildfires has more than doubled in the last two decades.

Other important factors such as population growth at the wildland-urban interface and inadequate or inappropriate management of state, federal and privately owned forests exacerbate the increasing risk.

As the situation worsens, insurance premiums will tend to rise to a point where they may no longer be affordable. In some regions, coverage may be withdrawn altogether. This will widen a “protection gap” of uninsured disaster losses, which Swiss Re currently estimates at $ 1.2 trillion (about 75 percent of total financial losses).

Some companies are particularly affected. Ski resorts and wineries, for example, are often surrounded by trees and crops and are particularly vulnerable to direct and indirect effects from forest fires.

Although there is no simple solution, innovation in the form of parametric risk transfer helps the public and private sectors to find new opportunities to complement their traditional compensation coverage in the face of a changing climate.

Why parametric risk transfer is a good option for natural fire coverage

Parametric solutions rely on measurements of the intensity and location of the event to determine payouts. A policy can, for example, be designed so that it pays a pre-agreed amount depending on the footprint of the wildfire that reaches certain areas.

While damage from a tropical cyclone can vary dramatically from small to complete depending on countless factors, damage from wildfires tends to be binary: If the fire footprint reaches a particular asset, the asset is likely to be completely lost. Therefore, wildfires are well suited for parametric treatment, as the hazard site largely determines the loss outcome.

Remote sensing methods to provide this type of information have evolved significantly over the last few decades thanks to more satellites and better instrumentation. With these range capabilities, (re) insurance companies develop parametric contracts that rely on metrics that are often public, free, and made available in near real-time, such as those provided by NASA’s Fire Information for Resource Management System.

Vulnerable infrastructure such as highways, access points or even parts of the forest itself can be protected through a parametric policy.

More often than not, direct damage is less worrying than financial damage caused by interruption of operations. Mountain resorts and hotels are an example of this. Parametric insurance can be used by these companies to supplement their traditional coverage with a tool similar to a hedge. Vulnerable infrastructure such as highways, access points or even parts of the forest itself can be protected via a parametric policy that responds immediately if a wildfire affects them, causing direct or indirect financial loss to the business.

Parametric innovation provides more capacity

Long-term and well-established insurance companies as well as new (re) insurance companies and capital markets can offer coverage on a parametric basis, which increases the total capacity available. Differentiation in pricing and risk appetite is primarily driven by capital providers’ views on the frequency of wildfires in a particular location.

In recent years, we have seen the emergence of models that use a variety of data sources and techniques that classical approaches ignore. New models account for burned areas with update cycles that are much more frequent than the multi-year model release plan we typically see in the industry. This allows for more accurate and dynamic pricing of parametric solutions.

Differentiation of markets using these new modeling capabilities lies in being able to identify areas where their perceived risk is lower than what the broader market suggests. Their value proposition consists of “separating out” parts of exposures or zones that most insurance companies may discard, but which they think they can subscribe to at an affordable premium.

Since parametric solutions do not require complex and expensive loss adjustment operations, the access barrier is lower for newcomers to the room. Lower costs, combined with innovations in remote sensing and modeling, will have the effect of bringing new capacity to complement existing traditional insurance availability.

An endless season of smoke

Businesses and communities have in recent years woken up to the worsening threat of direct property loss due to wildfires. While direct fire damage remains an issue of immediate concern, there is another danger on the horizon: increased direct and indirect losses due to smoke from forest fires.

The U.S. West Coast used to experience smoke in the air from October to May due to wood burning stoves in homes in the winter, burning wood waste in the fall and spring, and other agricultural or prescribed fires. Industrial operation was the only significant source of smoke that continued throughout the year. But today, frequent wildfires have added another source of smoke over an increasingly long summer season, exacerbating what could be called an endless season of smoke, which extends from January to December.

As we see for direct natural fire risk, the need for capacity to cover smoke-related damage will increase.

The air we breathe contains particles such as dust, pollen and mold, called PM10 or particles with a diameter of 10 micrometers or less. The incomplete combustion of organic compounds that occurs during wildfires adds smaller PM2.5 particles of 2.5 micrometers in diameter or less to the air. As they are smaller and lighter, these particles travel longer, affecting a larger portion of the population. They are of paramount concern from a health perspective because their size allows them to get deep into our airways in our lungs, where they can cause a variety of medical conditions, from impaired lung function to heart arrhythmias or heart attacks.

Winemakers in wildfires have had to deal with the increased potential of seeing their vineyards and facilities burn, but have also struggled with smoke affecting the quality of their grapes. Perhaps more far-reaching is the potential impact on work compensation schemes for companies whose activities naturally expose workers to more hours outdoors.

As we see for direct natural fire risk, the need for capacity to cover smoke-related damage will increase. Parametric solutions are poised to emerge as opportunities to provide additional coverage alternatives in this area, possibly using instrumental networks similar to those already in place in the civil society.

Parametric solutions and community-based insurance

While a changing climate continues to present challenges with insurance coverage, Guy Carpenter promotes the concept of “Community-based disaster insurance”, an example of a public-private partnership to attract insurers to offer affordable protection to at-risk communities. A mechanism that provides credits for no or low losses creates an incentive to introduce countermeasures. Prevention measures, in turn, can be met well by parametric solutions, for example by excluding buffer zones with a low risk of wildfires, which further reduces the premium.

As communities and businesses move forward in their efforts to protect themselves, parametric options that pay quickly and help offset any sources of loss will increasingly offer more options to complement traditional insurance solutions.

William

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