The Role of Scientifi c Modelling and Insurance in Providing Innovative Solutions for Managing the Risk of Natural Disasters - Reducing Disaster: Early Warning Systems for Climate Change - page 325

adequate systems. Indemnity insurance provides compensation for actual losses, up
to the limit specifi ed in the insurance policy, and requires the insured to demonstrate
that the loss has occurred. Index-based insurance, also known as parametric insur-
ance because of its reliance on a parametrical model, offers an alternative to tradi-
tional indemnity insurance for managing risk (Skees 2008 ).
Indemnity insurance relies on loss assessment, requiring expensive and time-
consuming evaluation of the weather-related loss. A substantial challenge for
indemnity insurance arises from information asymmetry between the insurer and
the insured. For example, adverse selection refers to the fact that individuals at high
risk are more likely to buy insurance because the insurer cannot effectively dis-
criminate against them, usually due to lack of information about the particular indi-
vidual's risk. Furthermore, moral hazard describes a tendency of individuals to
change their behaviour and take greater risks because the insurer will pay for any
losses that might arise. In contrast, index-based insurance uses an objective and
independent index based on publicly available measurements such as offi cial yield
records, satellite information or weather data to decide when payouts are triggered
(Box 17.4). This approach reduces transaction costs and provides immediate com-
pensation, making it affordable for producers and a viable product for countries
without a developed insurance market. Index-based insurance relies on innovative
science and technology, public-private partnerships and international risk pooling in
order to enable risk sharing across local and global scales. Scratch cards and mobile
top-ups are currently being used as a means of paying premiums.
Index-based insurance is particularly attractive for managing environmental risk
and has been successfully piloted for both development and disaster relief. Ethiopian
farmers have the option of working on irrigation and forestry projects or using cash
to pay for insurance products, developed by the World Food Programme (WFP) and
Oxfam America and reinsured by Swiss Re, which will compensate them if a severe
drought affects their crops. Index-based insurance initiatives are removing the bar-
riers of climate risk at the level of individuals, banks, cooperatives and government
in many countries including India, Mongolia, China, Nicaragua and Thailand (IRI
2009 ). Alongside other risk management policies, index-based insurance offers a
means of building adaptive capacity and resilience through risk transfer, increasing
access to credit and incentivising risk reduction via appropriate price signals.
Index-based insurance faces many challenges such as the need for training and
education about this relatively new form of insurance and the behavioural change
required for its acceptance. In practice, the accuracy of the index is constrained by
the duration and quality of the available data, which is a considerable challenge in
developing countries. Inadequate modelling and a lack of data may result in basis
risk, whereby losses will be sustained where the insurance product does not provide
compensation.
There is a role for governments and aid agencies to fund the infrastructure
required for collecting meteorological, loss and socioeconomic data in order to eval-
uate the feasibility of index-based insurance. This could provide ample opportunity
for the private sector and is of great importance for assessing climate variability and
long-term environmental change. In practice, index-based insurance will only be