We are debunking four myths about parametric insurance for renewable energy
Parametric insurance has been around since 1990s although the reinsurance industry has been using the parametric structures with catastrophe bonds for more than 30 years. Back then it was considered a novel product, but it may now be reaching new levels of popularity with the renewable energy investors and producers due to rapid advancement of technology and increasing quality of data around the world. For example, insurance companies can now build better indices to approximate the yearly average energy production of a windfarm and the insured can protect his revenues using index based parametric insurance.
One of the key motivators for the companies to purchase such insurance is its efficiency. The wordings have only a few pages, the indemnity amounts are clearly defined and the Insureds avoid lengthy claims investigations, coverage disputes and payment delays.
Flexibility is also another important factor that contributes to the adoption of the product. All the parameters can be tailor made to perfectly suit the risk management objectives and the Insured is also free to use the payouts the way he likes, unlike traditional insurance. Basically, an index is triggered, payout is made – no questions asked.
Another key criteria is the reduction of volatility, hence, the predictability of future revenues, transparency and objectivity of underlying parameters by applying parametric insurance as a protection against weather underperformance.
Despite its efficiency and speed the use of the product has been limited, at best. We decided to investigate the intrinsic details of the coverage and debunk common myths associated with index-based insurance solutions for renewable energy sector.
Myth #1 – parametric insurance is not suited for SME and mid-corporate buyers
Although initially designed to transfer high and catastrophic risks on a country level especially in regions like Caribbean, advances in data science, sensor technology and artificial intelligence have allowed for the creation of a broader assortment of informational indexes. This opened the door to new applications for parametric insurance that go well beyond the traditional natural catastrophe uses. The payout schemes have evolved from the eye of a tornado going through a specific geographical circle through a modular payout based on the speed of wind at a precise location, ensuring incremental payouts according to the exact nature of the catastrophic event.
It is a common misconception that parametric insurance can replace the traditional indemnity-based insurance coverage. It is a complementary coverage and should be purchased together with the traditional property damage and business interruption policies.
Renewable energy industry is heavily dependent on the availability of the financing. Therefore, index-based insurance, also known as sun or wind resource volatility insurance, provides additional protection to the investors while it stabilizes the revenue streams and increases the risk rating of the project.
Project managers face a project risk transfer gap, which occurs between the contractual warranties and available insurance coverage. Whilst the traditional insurance contracts facilitate the transfer caused by man-made (machinery breakdown, fire etc.) and natural perils, parametric insurance is designed to transfer the weather underperformance risk where traditional policies apply exclusions or simply do not respond to specific adverse events such as insufficient or excess resource availability. According to GCube, the weather risk gap of insurance is estimated to reach over 56 billion USD.
Myth #2 – parametric insurance is complicated
Let’s start at the beginning. The Oxford Dictionary defines the adjective parametric as “relating to or expressed in terms of a parameter or parameters”. When applied to insurance, that means coverage is triggered by a parameter – i.e. a metric or an index – that is easy to determine. An insurable trigger needs to be fortuitous and insurers need to be able to model it. Parameter or index used for the basis of a parametric insurance solution must be objective (i.e. independently verifiable), transparent, and consistent. This is important for investors, as it eliminates the information asymmetry and the moral hazard.
While parametric insurance has all the advantages of the cost-effective risk mitigation and transfer tool for renewable energy projects, it does have its shortcomings. This phenomenon is often referred to as Basis Risk. It is commonly considered as a “near-miss factor” or the event where the trigger index does not perfectly correlate with the underlying risk exposure, resulting in a situation where a policyholder suffers a loss but does not receive payment. For example, measured wind speed might fall within the insurable range, but the insured did not suffer loss of revenue below the pre-determined index, hence no payout.
When we speak about the sun or wind resource volatility index, we usually refer to the double-trigger policies, which require that a pre-determined parameter threshold is reached and the insured has sustained the actual financial loss, e.g. loss of revenue due to lack of wind.
The index is usually structured as a function of wind speed or solar irradiation level, and plant efficiency factor. The insured can choose the desired protection by defining the Strike, acting as a deductible, and the Exit point. The annual estimated energy production between the Strike and Exit represents the Total Sum Insured. The premium is consequent upon the wind speed historical volatility and the Strike and Exit scenario chosen by the client.
In case production energy production falls below a certain level, e.g. 98% (Strike), the payout is activated until the Exit scenario, e.g. 80%. The magnitude of the payout is determined by the actual loss of generation income for the plant. Hence, the index fluctuates, whereas the actual revenues remain almost constant. The volatility is reduced, and the project delivers revenue streams in accordance with the financing model.
Myth #3 – parametric insurance is expensive
Contrary to the common belief, parametric insurance is very cost-effective provided that correct index has been structured for the specific renewable energy type.
According to Modern Energy Management, the majority of renewable energy projects face significant cost overruns, which are mainly due to the failure to properly identify and transfer project risks. This creates often a huge gap in risk transfer, whereas the investors and lenders end up assuming greater project risk than they should. One of the main reasons is that the project contracts and insurance is often developed in isolation.
Parametric insurance reduces volatility of the projected income, thus enabling a steady, predictable stream of revenues that appeal to lenders and investors alike. Quite often it helps to reduce cost of capital by pushing the interest rates down and increasing the debt/equity ratio.
Investors must juggle with all the characteristics of the project to maximize the revenues generated from their investment. Vaisala has calculated that 33% of the total energy production uncertainty for a windfarm project comes from both the historical and the future wind resource variability. This is exactly what the index based parametric insurance is designed to mitigate.
For example, many solar farms secure their financing at P95 level, hence, leaving a 5% chance of not achieving the planned annual energy production. However, after reviewing over 200,000 solar farm projects, WindAnalytics has found out that the P99 radiance probability of a catastrophically bad year is not 1% as mathematically calculated but rather 6.3%. The consequence is that a project financed for 7 years with a loan size based on 1xP99 metric results has a 37% chance of defaulting in a given year.
Parametric insurance can appear costly when compared to the traditional indemnity-based insurance. The premium may range between 0,5% and 5% of the purchased limit, whereas the conventional policy will have a premium rate much lower than the index-based solution. Such comparison is not entirely correct. Property Damage and Business Interruption policies cover loss of or damage to insured property and the business interruption resulting therefrom. They require a physical loss or damage in order for the coverage to be triggered and have extensive list of warranties, subjectivities and exclusions incorporated in their wordings. Index-based policies, however, do not require a physical loss to reimburse the insured for the economic cost of the adverse event.
The index based parametric insurance can be structured in many different ways. The scenario, which involves a low Strike and high Exit, will result in minimum premium level. On the opposite, if the client choses a very high strike and a low exit, the expected premium will be a lot higher. The Insured will have received larger payouts. The product should be structured to match key project objectives, from securing the lenders and improving the credit rating of the project to reducing the volatility of future revenues to a minimum level.
Myth #4 – regulators do not approve parametric insurance as insurance
Insurers offering parametric insurance have to overcome the regulatory challenges. Those who are already offering such products usually use double trigger policies, which require the proof of loss by the insured even though both types of policies function similarly to derivatives. The main difference is the insurable interest, which derivatives lack. In certain countries, where the regulatory framework does not explicitly address the use of parametric, it is important that the indemnity payment does not exceed the actual sustained loss and that the insured can prove existence of the same.
One of the main issues regarding risk management in renewable energy projects is the confusion on how to best manage weather-related volume risks. In order to provide answers to this, insurance broker should be involved as early as the planning stage of the project, i.e. before the contract is drafted, negotiated and signed. Early involvement ensures the closing of the risk transfer gap and securing the best terms and conditions for the project`s finance. Parametric insurance can be tailored to match project of any size and budget.
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