Climate Change: An Actuarial Perspective (Part 2)

This is continuation of the climate change: An Actuarial Perspective article. To read the first part kindly click on the link. In this article, we will get to know about the financial instrument that are there in the market to mitigate the risks of climate change.

Since we know that climate change can do a lot of damage, we have to manage the risk associated with it. There are various instruments in the market to measure the destructibility of climate change, insure the damage and fight the effects.

Financial instruments:

ND-Gain Index (Notre Dame – Global Adaptation Initiative):

This open source index summarizes a country’s vulnerability to climate change in combination with its readiness to improve resilience. It helps government, private institutions to know their country’s standings in terms of the vulnerability. The higher our score in ND-GAIN Index, better it is for us.

This ultimately helps in lowering the risk and enhancing readiness. There is a linear relationship between ND – Gain Index and GDP Per Capita. Therefore, we can conclude that with a better latter, the country might be less vulnerable to the effects of climate change. You can view the ND-Gain Index from this link.

Calculations for ND -Gain Index:

               Vulnerability scores can be measured in terms of food, water, health, ecosystem, human habitat and infrastructure. The indicators for readiness of a country to measure ND – Gain Index can be divided into Economic, Social and Governance Readiness. A country will have to thrive in above indicators to be completely ready. There are a total of 45 ND-GAIN indicators calculated from 74 different data sources. ND-GAIN index follows transparent and reliable procedure for data conversion to index.

The procedure to calculate ND-GAIN index is:

Step 1: Collection of raw data and do structuring of data.

Step 2: The missing data can be interpolated or marked as “missing”

Step 3: A baseline minimum and maximum is calculated from the raw data. If the data is positively skewed then 90th percentile value is selected and if it is negatively skewed then the 10th percentile value is selected, for the maximum or minimum baseline value.

Step 4: Reference data points are set to measure which performance is best, that is, 0 vulnerability and full readiness. These reference points come in handy when comparing the performance of a country to the best possible outcome.

Step 5: Scores are calculated bases on below formula.

Score = Direction – ((raw data – reference point) / (Baseline maximum – Baseline minimum))

Direction = 0 if calculating vulnerability indicator

                  = 1 if calculating readiness indicator

Therefore, score gives us the values of each indicators ranging from 0 to 1. This makes it easy to compare scores of different indicators.

Step 6: Arithmetic mean of indicators are calculated in respective vulnerability or readiness constituent. The only thing left now is to compute both the figures as one to come up with a final value.

Step 7: Now we derive the value of ND-GAIN Index by the below formula

ND – GAIN Score = (Readiness score – vulnerability score + 1) * 50

Green Bond:

Green Bonds are just like any other bond but are specifically “ear marked” to finance “Green” projects. The money raised by Green Bonds are specifically used on assets or business activity which benefit the environment. Green Bonds was an initiative first made by the World Bank in 2008. World Bank took the lead to fight the harmful effects of climate change and came up with an innovative solution. Since 2008, World Bank has issued over USD 13 Billion in green bonds through more than 150 transaction in 20 countries.

ILDS regulations govern the issuance of Green Bonds in India. India has become the second largest market for emerging Green Bond after China which is very good news for India.

To assign a bond as “Green”, it should finance at least one of the following categories:

  1. Renewable and sustainable energy (wind, solar etc.)
  2. Clean Transportation
  3. Sustainable water management
  4. Climate Change Adaptation
  5. Energy Efficient
  6. Sustainable waste management
  7. Biodiversity use
  8. Sustainable land use

Not every company can go ahead and issue a Green Bond. There are certain prerequisites for companies to satisfy for issuance of bonds. These requirements are net worth, Rating parameters and Track record of the company.

Catastrophe (CAT) Bond:

 A CAT Bond is specially designed for Insurance companies to raise funds during the time of catastrophe like earthquakes, tornados, etc. It is a high yielding debt instrument that the issuer will only receive money if the said natural disaster takes place. It provides higher interest rates than most fixed interest securities. If the event does takes place then the obligation to pay interest and return the principal is either deferred or completely forgiven. These are short term bonds so the risk of not getting interest and principal is mitigated by the duration.

Individual investors do not usually invest in CAT bonds. Most of the investors are pension funds, hedge funds and other institutional investors. There are indexes for CAT bond returns. It is a bond specifically designed for insurance and reinsurance companies but over the years Government of many countries are issuing CAT bonds. Government issue such bonds to reduce their cost at the time of catastrophe.

Microinsurance for climate change:

Microinsurance is for the protection of low – income population against specific risks. These policies can include damage of property or life due to drought, flooding and tropical storms. Microinsurance mitigate the risk of impact against immediate events. Microinsurance is more popular in under-developed and developing countries. An insurer will only be motivated to issue more of microinsurance policy if there are large volume of people applying for it. It is possible that if the volume is less then it is an unprofitable business for the former.

Microinsurance has socio-economic benefits. It contributes to poverty alleviation and make policyholders less vulnerable to risks and more resilient.    

Index Based Insurance:

An insurance policy may never cover all the risks that a farmer faces. Weather is not the only reason behind failure of crops. After damage of crops, farmers are also under huge debt due to high interest rates. Index based insurance can be of rainfall weather index, drought weather index depending on the weather a crop is vulnerable to. Weather based index insurance has a payout based on the index and not specifically on the loss of crops. It covers a radius of 12-15 KM for a particular area.

Calculation for index based insurance:

The index is calculated based on the past 30 years data of that area. A relationship between weather and the yield is calculated using parametric and non-parametric techniques. Regression Analysis calculates the relationship between the two. Calculation of the whole index is majorly based on this analysis. Surveys calculate the cost of cultivation and expected profit or loss, which calculates the maximum payout.

The premium can be calculated through two methods which are burn analysis or numerical integration. Burn analysis uses past data and calculates hypothetical payoffs for each year. Then, the final gross premium is decided after adjusting loading expenses, commission and profits. In numerical integration, a distribution is fitted on the event probability and the expected payout is calculated. Premium can be calculated after conducting statistical tests for fit of distribution.

Government compensation:

There are different policies of different government on how to tackle the victims of climate change. There are many organizations involved in climate change research, policy making and education. These organizations are U.S. Environmental Protection Agency, Intergovernmental Panel on climate change (IPCC), National Center for Atmospheric Change (NCAR) and many more. There are great initiatives like Green Climate Fund and Paris Agreement for the mitigation of risks due to large weather deviations.

There is a famous saying that “Climate is what you expect and weather is what you get”. As Actuaries we do modelling and see how mortality rates responds in different climatic situations. There is one conclusion that most climate models give that if the current rate of increase in temperature goes on then the mortality rates are also going to spike. Researchers have already found out that our life expectancy is decreasing due to the warmth in temperature. Thus, climate change is affecting our mortality models as well.

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B.Sc. Actuarial Science Graduate.

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