Climate Risk Insurance – specific terms

This glossary provides an overview of relevant terms to the thematic intersection of financing and insurance instruments with overall disaster and climate risk management. It, therefore, limits coverage of terminology from these fields to concepts and definitions which are directly relevant for the solution space of climate risk insurance in the overall context of the InsuResilience Global Partnership. Explanations have been formulated in layman’s terminology where possible to make this glossary accessible to partners from various thematic backgrounds.

For ease of navigation, the glossary is arranged alphabetically. References to terminology which is else-where defined in this glossary are indicated with italicized typeface and a direct link to the definition.

Actuaries / Actuarial science

Actuarial science converges knowledge and skillsets from probability, financial theory, and computer science. Actuarial science professionals, actuaries, assess the financial risk of a particular situation using this broad knowledge and skillset to determine the pricing of various (re)insurance policies in various contexts. Public and private institutions rely heavily on actuarial science to determine the relative risk of various decisions. As such, actuarial science can help identify and encourage risk-reducing behaviors that would result in lower premiums.

Alternative Risk Transfer (ART)

ART refers to both a variety of alternative risk transfer mechanisms, as well as the transferring of risks to alternative risk carriers, particularly capital market investors (as opposed to traditional (re)insurers).

ART emerged in the late 1990s when (re)insurers began looking for further risk capacity to offload their natural catastrophe and weather risks; in line with that, capital markets began to view natural disasters and weather as a new asset class, as investment banks designed new capital-market based instruments to transfer natural catastrophe and weather risks to capital market investors. Several new risk transfer formats emerged, such as cat bonds, catastrophe swaps, parametric insurance solutions, sidecars, and weather derivatives.

Index-based insurance can be seen as a direct byproduct of ART, as transferring risks on a parametric basis allowed for higher transparency and standardization, and therefore created higher interest from investors. Reinsurers, brokers and investment banks alike, therefore, began to develop different trigger mechanisms to be used within cat bonds, cat swaps, and weather derivatives. With an increasingly so-phisticated investor base, this has changed over the years, as dedicated ART investment funds are now able to invest in indemnity-based formats as well. However, the ART market was vital in creating those types of risk-transfer arrangements which are now predominantly used in the context of disaster risk finance for vulnerable countries.

Basis Risk

In financial market theory, basis risk describes the risk that a hedging strategy leads to excess gains or losses and hence does not protect as intended. A hedging strategy, to briefly note, is a strategy to protect against financial losses (such as purchasing insurance to protect against risk uncertainty). Basis risk can be elevated when the investment that needs to be hedged, e.g., the oil price, is imperfectly correlated with the asset being used as a hedge, e.g., a futures contract on oil prices.

Applied to insurance, basis risk is the potential difference between the beneficiary’s losses and the payout it receives from the insurance contract. Basis risk is therefore inherent in index-based insurance, as the payout determined by a parametric trigger may be higher or lower than the actual loss suffered by the beneficiary. Basis risk can be mitigated by customizing the index to match the client’s exposure and vulnerability profile, but it cannot be fully eliminated. Reinsurers sometimes provide basis risk covers as an add-on to index-based products.

Read more on basis risk from our members, Willis Towers Watson, at https://blog.willis.com/2014/12/what-is-basis-risk-and-why-does-it-matter/

Beneficiary

The person(s) or party(is) which benefit(s) from protection under a (re)insurance coverage scheme. Beneficiaries may be direct policyholders (e.g., individual smallholder farmers) or indirect recipients of protection under a broader policy (e.g., a household within a community which is insured against coastal flooding). See Direct Insurance and Indirect Insurance.

Broker

An intermediary who negotiates (re)insurance contracts between a (re)insured and (re)insurer on behalf of the (re)insured. Brokers can be involved at various stages of the insurance value chain, providing services in the area of risk modeling, (re)insurance program structuring, program placement, capital management, and alternative risk transfer.

Capacity

  1. The measure of a (re)insurer’s financial ability to issue contracts of (re)insurance, usually determined by the most significant amount a (re)insurer can potentially pay out for a given risk or by the maximum volume of business it is prepared to accept.
  2. The ability of the market as a whole to manage risks by way of reinsurance.

Catastrophe Bond (Cat Bond)

An Insurance-linked Security (ILS) that is used to transfer natural catastrophe (re)insurance risks to the capital markets. For this, a particular purpose vehicle (SPV) is set up and issues bonds to investors, which pay capital into the SPV and receive a risk-adequate coupon on their paid-in capital. The beneficiary of the Cat Bond (a corporation, (re)insurer or public risk pool) then enters into a risk transfer agreement with the SPV. If a natural catastrophe exceeds a predefined loss threshold (either on an indemnity or index basis), a preset amount of the capital paid in by investors is paid out from the SPV to the (re)insured. A cat bond is generally used for high-severity-low-frequency risks due to investors‘ risk-return requirements, which usually limit investments to catastrophe risks in 25 to 200 years return periods (see return period and risk layer). Investors’ motivation is both aimed at diversifying their investment portfolio with an uncorrelated risk and generating relative yield advantages compared to mainstream fixed income instruments (e.g., government bonds, corporate bonds).

Claim

A demand by a (re)insured for indemnity under a (re)insurance contract. A claim will be met if the injury, damage or liability at issue was caused by a (re)insured peril which is not excluded and is within the limits of the contract. Depending on the type of (re)insurance model and contract, making a claim can be more or less cumbersome for beneficiaries. In the interest of providing immediate disaster relief to poor and vulnerable communities which may have less technical capacity to submit a claim after such an event, index-based insurance can ease the process of making a claim, as payouts are issued automatically upon the triggering of specific parametric indicators (e.g., wind speed, rainfall, earthquake magnitude, etc.). Some (re)insurance providers may still require post-payout proofs of loss to protect themselves from losses through unnecessary payouts.

Climate Risks

Climate risks in a narrow sense include adverse, sudden onset, extreme weather events such as tropical storms, floods or droughts. While these risks are expected to be exacerbated by climate change, they are not primarily caused by climate change. On a broader sense, climate risks also include slow onset events such as sea level rise, glacier melting and ocean acidification, which are a direct effect of climate change. However, these risks are generally not addressed via climate risk insurance, as their slow onset character calls for different adaptation measures.

Climate risks are highly complex and multifaceted and are accordingly difficult to measure regarding where, to what extent, and how frequently losses and damages will occur. Providing insurance for climate risks, therefore, requires sound risk models to assess and price the respective risks.

Co-Insurance

Co-insurance is a fairly typical practice for insurers where no single insurer wishes to take on board the entire risk. In this case, two or more insurers jointly assume risk under a single insurance policy, where each insurer considers an agreed upon the proportion of the total risk. One insurer usually is the leader. This practice of distributing the cost of risk can enable policyholders to gain coverage for more substantial risks while keeping the costs of that risk affordable to the involved parties.

Concessional Support / Financing

In the context of disaster risk finance, concessional support refers to all forms of financial and non-financial support from development partners, which aim at improving governments‘ financial and technical capacity to address the financial risks they face from disasters. In many cases, discussions around concessional support will focus more on financial support forms, i.e., concessional financing, as in many vulnerable countries insurance remains underutilized due to a lack of funds to pay for premiums. Concessional financing, either directly via premium financing or indirectly via support tools that lower overall insurance costs, can help increase the demand of those instruments. The primary forms of concessional support are:

  • Premium financing
  • Capitalization of a risk pool
  • Payment of reinsurance costs
  • Subsidizing operational costs
  • Technical Support, incl. For modeling, product structuring, monitoring, etc.
  • Capacity Building
  • Financing risk reduction measures that ultimately lead to lower premiums

Contingency Plan

A contingency plan is a plan of action to respond to certain potential adverse events (contingencies) which could occur and could cause losses. Contingency planning is ultimately about preparing for possible future disruptive unknowns. Contingency plans emerge from thorough risk analyses and assessments as a means to both manage/mitigate that risk and to respond to potential occurrences. As a staple component of climate and disaster risk management, contingency planning can be defined as a management process that analyzes disaster risks and establishes procedures in advance to enable timely, effective and appropriate responses to catastrophes. Within sovereign-level disaster risk finance instruments, payouts can be tied to pre-arranged contingency plans to ensure that the disbursed funds are channeled to immediate disaster response measures which provide relief to the targeted beneficiaries.

See further information at https://www.unisdr.org/we/inform/terminology

Contingent Credit

Contingent credit instruments are prearranged forms of financing that are triggered by a predefined contingency, i.e., a potentially harmful event that may occur in the future.

Within disaster risk finance, contingent credit is pre-arranged lines of credit that governments can activate at predefined borrowing conditions (interest rate, duration, credit volume) if a natural disaster with predefined conditions occurs. The main benefit of these instruments is the rapid access to funds for disaster response without having to issue debt out of a distressed position after disasters, which would generally imply higher interest rate requirements from investors.

The World Bank’s Catastrophe Draw Down Options (Cat DDO’s) are to-date the most used type of contingent credit for disaster risk finance and is generally used for mid-frequency-mid-severity events, with insurance coverage providing “on-top” financial protection for low-frequency-high-severity events.

Crop Insurance

Insurance coverage designed to protect farmers, processors, and wholesalers from climate risks which threaten harvests. Payouts by such schemes can be delivered directly to farmers or the more broadly affected community, depending on the design of the mechanism. Crop insurance in climate-vulnerable contexts is usually implemented via index-based insurance mechanisms. See further: direct insurance, indirect insurance, and index-based insurance.

See for example https://insight.wfp.org/crop-insurance-eases-burden-on-farmers-in-southern-kenya-948d1be6333a

Derivatives

Insurance derivatives represent a form of alternative risk transfer in offering an alternative means to traditional (re)insurance to protect against losses. Insurance derivatives, similarly to catastrophe bonds, are a means to transfer risk to the capital market – as opposed to transferring risk to a (re)insurer through a (re)insurance policy. In contrast to traditional (re)insurance protection, insurance derivative providers must back their offered protection with a collateral sum of money equal to the total maximum payout. Investors providing insurance derivatives place this collateral with a third party – such as a bank. As with a traditional (re)insurance product, insurance derivatives offer protection against losses in exchange for a premium – paid directly to the investors. In the event of a covered loss occurring – based on the occurrence of a pre-agreed upon index (i.e., wind speeds over 100km/h) – the payout is issued directly from the third party holder of the coverage sum (e.g. a Bank) to the policyholder.

For the policyholder, one of the advantages of an insurance derivative form of protection is the security that the capital behind their coverage is guaranteed and immediately available for a fast payout (often faster than traditional (re)insurance payouts). Furthermore, the competitive premium rates for insurance derivatives provide prospective policyholders with the benefit of being able to bargain with other, traditional risk transfer providers for lower premium rates.

For the coverage provider – that is, investors offering insurance derivatives – these policies are attractive because they have been transferred to the capital market and can thus be traded and speculated upon. While the trading of these policies in no way impacts the coverage available to the policyholders as their collateral coverage sum remains intact, it offers investors a means by which to make further profits through speculation on the risk/value tradeoff of various policies being traded.

For example, an investor offers an insurance derivative coverage against hurricane damage to a business for a value of 100 Mio. USD. As there is a tropical storm system likely heading toward that business, this investor sells that derivative to another investor for a value of 80 Mio. USD, thus accepting a loss of 20 Mio. USD as opposed to the potential total loss of 100 Mio. USD. The investor who purchased this derivative may have assessed the risk and found that the value at which the derivative is being sold was still cost-effectively a good deal, given the uncertainty surrounding the risk of loss.

Disaster Response

Disaster response is the reactive part of disaster risk management, which is focused on providing immediate assistance to save lives, improve health, and support morale after a disaster strikes. Disaster response activities include evacuation, search and rescue, damage assessment, infrastructure restoration and construction, and provision of emergency health and social services (e.g., shelter, nourishment, transport). Disaster response can be altogether improved if it is thoroughly incorporated into ex-ante contingency planning. Disaster risk finance and insurance solutions can play a crucial role in disaster response due to the rapid nature of these solutions’ payouts in the aftermath of a disaster (as opposed to the long delays associated with traditional humanitarian aid or other fiscal options, e.g., issuing debt or raising taxes). See further: Disaster Risk Finance and contingency plan.

Further reading at https://www.unisdr.org/files/3769_ai504e00.pdf

Disaster Risk Finance

In the humanitarian and international development context, disaster risk finance defines all instruments aimed at strengthening financial resilience or providing financial protection against natural disasters and extreme weather events for vulnerable countries and communities. This encompasses both insurances as well as risk financing elements. Usually implemented on a sovereign level, the central goal of disaster risk finance is to assist more rapidly and reliably to those in need when a disaster strikes by using tools like insurance and contingent credit to finance rapid and reliable response to emergencies.

See further the work of the World Bank’s Disaster Risk Financing and Insurance Program: http://www.worldbank.org/en/programs/disaster-risk-financing-and-insurance-program

Direct Insurance

Direct insurance refers to insurance schemes which operate on a micro or mesoscale where (re)insurers have contracts directly with the people or parties receiving coverage. For example, direct climate risk insurance schemes provide coverage directly to smallholder farmers instead of operating through a contract with the government.

Excess of Loss (re)insurance

In excess of loss (re)insurance contract, a (re)insurer covers the proportion of the policyholder’s losses more than a predefined threshold (or attachment point) and up to a preset limit, as determined by an exhaustion point. Excess of loss insurance is most prevalent in catastrophe reinsurance, where the losses of an insurer per event are layered using attachment and exhaustion points. Explained in other terms, the insurer will retain per event losses up to a certain amount (i.e., USD 100m) while reinsurance may then be purchased to partly or wholly cover losses within the next risk layer (i.e., per event losses between USD 100m and 200m). The per event limit of losses for the reinsurer here is USD 100m, while the exhaustion point of the entire coverage (retention + excess of loss reinsurance) is at USD 200m in per event losses. The following is an example of what this excess of loss structure may look like for a US insurer purchasing reinsurance for tropical storm events in Florida:

  • Retention: USD 0 to 100m, i.e., per event losses up to USD 100m are retained by the insurer
  • Layer 1: per event losses more than USD 100m (attachment point) up to USD 200m (exhaustion point); the limit of damage for the reinsurer being USD 100m
  • Layer 2: per event losses more than USD 200m (attachment point) up to USD 400m (exhaustion point); the limit of loss for the reinsurer being USD 200m

Exclusions

Risks, perils or classes of insurance which are not covered under a contract and for which a reinsurer will not issue a payout. These risks, perils, or types of insurance may be excluded for a variety of reasons – including cases where potential losses are too catastrophic to be financially feasible for the (re)insurer, risks cannot be appropriately modeled and prized, or where losses can stem from easily-avoidable behavior or exposure. In the context of climate and disaster risk finance and insurance, exclusions in a coverage policy can be minimized by adequately embedding these mechanisms within a broader risk management approach to reduce the likelihood and severity of these risks.

Expected Loss

The average loss occurring for a particular (re)insurance contract, expressed in probabilistic terms (estimated likelihood), as computed by a risk model. For catastrophe risk insurance, this is usually the average loss a risk layer is expected to have on an annual basis, expressed in percentage of the layer’s limit. The expected loss is directly related to the return period – for example, a 1-100 year flood may equal a 1% expected loss, while a 1-5 year flood may correspond to a 20% expected loss. In the context of disaster risk finance, expected loss refers to the total loss to the government in infrastructure, disaster response costs, humanitarian costs, etc. which a country is seeking insurance protection is estimated to experience due to a specified peril. The total loss can be layered into different risk layers with individual expected losses to separate the risk the government wants to retain vs. the risk it wants to transfer out to insurers or capital markets.

Exposure (Catastrophe Exposure)

  1. Exposure refers to a body or a person’s susceptibility to risks and their relative likelihood to experience a loss from those risks.
  2. Within risk modeling, exposure refers exclusively to the geographic exposure of the insured assets as defined by its location about the modeled severities and locations of the covered peril.
  3. Exposure from the perspective of a (re)insurance company refers to the amount of potential loss an (re)insurance company is exposed to by a single catastrophic event, such as an earthquake or a hurricane. In this context, exposure is used to calculate the expected loss in conjuncture with vulnerability and hazard (expected loss = exposure + vulnerability + hazard).

See further at UNISDR’s Prevention Web Platform: https://www.preventionweb.net/risk/models

Hazard

Hazard is generally used synonymously with peril. Within risk modeling, the hazard component assesses the likelihood and severity with which covered events are expected to occur, leaving aside the exposure (i.e., where are the insured assets located and hence how exposed are they) and vulnerability (i.e., how prone are these assets to be damaged by the respective peril).

See further at UNISDR’s Prevention Web Platform: https://www.preventionweb.net/risk/models

Indemnity

Financial compensation which is sufficient to place the (re)insured in the same financial position after a loss as they were immediately before the loss. This amount is generally calculated based on the ultimate net (i.e., net of any other inuring insurance) loss of the beneficiary.

Indemnity-based Insurance

A (re)insurance contract which pays out compensation worth the ultimate net loss of a specific asset. This type of insurance can be useful in protecting high-value assets such as homes, where there is a relatively narrow scope of potential loss. Insurance payouts are determined based on an assessment of losses after an event has occurred.

Index-based Insurance

In contrast to Indemnity-based Insurance, Index-based Insurance pays out when specific parametric indices of the covered perils are exceeded (e.g., wind speed, rainfall). This allows for a more rapid payout of a pre-agreed amount based on the severity of the index triggered. By eliminating the need for claims settlement, Index-based Insurance provides for a broader range of coverage as losses that are difficult to assess and for which a price is more challenging to calculate can be included. Also, index-based insurance pays out substantially faster than indemnity-based insurance. For this reason, index-based insurance is frequently used within disaster risk finance instruments as it enables timely disaster response measures.

Indirect Insurance

Indirect insurance refers to insurance schemes which operate on a macro scale in contracts with governments (or government operated risk pools) rather than direct provision of coverage to the intended beneficiaries. In these cases, in the event of a disaster, governments receive a payout from the (re)insurer which is then distributed or channeled into disaster response measures to reach the people or parties which have been affected by the disaster.

Insurance

Insurance is the provision of financial protection against specific losses, typically provided in exchange for regular premium payments. The perils which are covered, the extent of compensation, and the cost of the premiums are agreed upon in the contractual agreement between the insurer and the insured. The insurer, in turn, is a party which provides this service by agreeing to financially compensate people, companies, or organizations for specific losses.

Integrated Risk Management

Integrated risk management, as defined by The Executive Committee of the Warsaw International Mechanism for Loss and Damage associated with Climate Change Impacts, includes risk assessment, risk reduction, risk transfer, and risk retention. Integrated risk management should aim to build the long-term resilience of countries, vulnerable populations, and communities to loss and damage. This can be done through the inclusion of social protection instruments and through the dispersal of information about financial instruments as well as tools which address climate risks to create an enabling environment and facilitate the uptake of solutions best suited to the policy context of each country or region.

Further reading at https://unfccc.int/topics/adaptation-and-resilience/workstreams/approaches-to-address-loss-and-damage-associated-with-climate-change-impacts-in-developing-countries#eq-3

See further at UNISDR’s Prevention Web platform: https://www.preventionweb.net/files/39990_3999088064ebroschuereirmweb1.pdf

Loss and Damage

Based on the UNFCCC definition of loss and damage, we define loss and damage as the adverse effects of climate variability and climate change which remain after climate mitigation and adaptation efforts to which people are not able to cope with or adapt to. Loss and damage stems from cases where 1) coping or adaptation efforts are not sufficient enough to avoid losses and damages, 2) coping or adaptation measures have associated costs which are not retained or compensated, 3) the gains of coping or adaptation measures are short-term but do not remain long-term, or 4) coping or adaptation measures are not possible.

Read further at https://unfccc.int/topics/adaptation-and-resilience/workstreams/approaches-to-address-loss-and-damage-associated-with-climate-change-impacts-in-developing-countries

(Risk) Layer

Generally, in excess of loss (re)insurance contract, coverage is divided into some consecutive layers – each corresponding to a range of expected loss severity (estimated damages) and loss frequency (return period, e.g., 1-100 year to 1-150 year events). Layers will progress from high-frequency, low-severity events to low-frequency, high-severity events (e.g., minor annual flooding to a 1-100 year flood). The risk layers are calculated with risk models in which a specific range of severity of loss is correlated to a specific range of loss frequency. The base risk layer of an excess of loss (re)insurance program will generally be retained, which refers to the risk/loss a (re)insurer or policyholder agrees to cover/pay personally. Losses beyond this deductible layer are then covered by a single or various (re)insurer(s), depending on how those (re)insurers wish to distribute their share of risk coverage. For example, in catastrophe excess of loss reinsurance, a single risk layer (covering, for example, all loss severities between 200m and 500m and corresponding loss frequencies of 1-100 year to 1-150 year events) may be split in an agreed-upon proportion between different reinsurers.

(Coverage) Limit

A coverage limit refers to the maximum amount an insurance company will pay out for a covered loss. An insurance policy can include multiple coverages – each for a different type of loss or risk – so it is possible that within one policy there can be multiple coverage limits. Furthermore, coverage limits for a single loss or risk can also vary if coverage is divided into different risk layers. For example, one (re)insurer may only cover losses up to the limit of the first risk layer (e.g., losses up to 100m), after which a separate (re)insurer may cover the second risk layer (e.g., for losses up to 200m). In this case, both (re)insurers have a coverage limit of 100m as they each only cover one risk layer, but the policyholder enjoys coverage for up to 200m in losses.

Market Penetration

Market penetration refers to the level of uptake a particular policy or the insurance industry in general enjoys. Penetration rate is measured as the ratio of premium underwritten in a specific year to the GDP. (Re) Insurers wish to increase market penetration to promote uptake of their products and increase premium income. Generally, a high market penetration should lead to a reduced protection gap, so supporting an increased uptake of insurance can be a viable approach to strengthening the financial resilience of vulnerable people.

Moral Hazard

Moral hazard is the idea that (re)insurance coverage may negatively influence policyholder behavior to encourage more reckless practice with a “don’t worry, it’s insured” attitude. This type of behavior could increase the frequency and amount that a (re)insurance company would need to pay out, which in turn would require a repricing of that policy which could eventually become unaffordable – leaving the intended recipient without risk protection and the (re)insurer without business. To avoid this scenario, (re), insurers build in particular clauses to define the conditions under which a payout is warranted.

National Adaptation Plan

The national adaptation plan (NAP) process was established by the United Nations Framework Convention on Climate Change (UNFCCC) as a way to facilitate adaptation planning in the least developed countries (LDCs) and other developing countries. National adaptation plans serve to identify medium- and long-term adaptation needs and develop and implement strategies and programs to address those needs. They are produced in a continuous, progressive and iterative process which follows a country-driven, gender-sensitive, participatory and transparent approach.

See further. https://unfccc.int/topics/adaptation-and-resilience/workstreams/national-adaptation-plans

Parametric Trigger

A parametric trigger is an integral component of an index-based insurance mechanism, which defines when a contract is to pay out to the policyholder. This trigger is typically based on parameters directly related to the risk that the policyholder is seeking to protect against, such as hurricane wind speed or rainfall total. These triggers must be carefully chosen to correspond accurately to specific expected losses and damages arising from the risk against which the policyholder seeks to protect themselves. The contingent nature of a parametric insurance contract, meaning that it pays out only when defined parameters are recorded or experienced, makes the payout mechanism predictable and rapid. This ensures both values for the policyholder and accurate pricing and formation of a risk management strategy for the (re)insurer.

Read further at https://www.unisdr.org/files/52828_jdevelopingrisksovereignrisk.pdf

Peril

This term refers to the possible types of climate and disaster risks – i.e., wildfire, flooding, drought, tropical windstorm, earthquake, etc.

Policyholder

A person or party who enters into insurance contract(s) wherein an agreed-upon person or party receives financial protection against agreed-upon events or losses in return for the payment of a premium. Policyholders may be separate from the beneficiaries of a policy if they are acting as an intermediary between the insurers and the recipients. See further: direct insurance and indirect insurance.

Premium

A premium is the monetary amount beneficiaries, or their intermediaries must pay in return for (re)insurance coverage.

Protection Gap

The protection gap is the difference between the insured losses and overall economic losses. This difference refers more specifically to the uninsured portion of the population. In the context of climate and disaster risk finance and insurance, the protection gap can be directly linked to macroeconomic consequences of natural disasters. In countries where there is greater market penetration, the macroeconomic impact of a disaster is lessened through reduced implications for socio-economic development (e.g., poor and vulnerable people slipping further or back into poverty), a reduced burden on taxpayers (for governmental losses such as infrastructure damage) and a faster return to normal socio-economic function (e.g. restored public infrastructure and services).

See further: https://www.genevaassociation.org/sites/default/files/research-topics-document-type/pdf_public/ga2014-the_global_insurance_protection_gap_1.pdf

Reinsurance

Reinsurance is the provision of financial protection to insurance companies. Reinsurers, the companies providing this service, handle risks that are too large for insurance companies to manage on their own. This service makes it possible for insurers to offer more policies/coverage than they would otherwise be able to. Reinsurers also help spread out accumulative risks, e.g., natural disasters like earthquakes and hurricanes. Such an event could result in more claims that the primary insurer could pay out without going bankrupt since there would not only be a high dollar amount of claims, but they would also all be made in the same period. By transferring part of the risk (and portion of the premiums) of insuring against these events to several reinsurers, insurance companies can stay solvent and provide these services at affordable rates to individuals and parties.

Return Period

Return period refers to the probabilistic frequency at which a loss event is expected to occur expressed in years, for example, a 1-in-5 year flood or a 1-in-100 year flood. The return period is also inversely related to the severity of an event. For example, a 1-in-100 year flood is expected to have a higher severity than a 1-in-5 year flood.

Residual Risk

Residual risk is the risk remaining after risk treatment. In the context of climate and disaster risk finance and insurance, this means the risk of asset or livelihood loss which remains after risk transfer options are in place.

Risk

Risk, in extensive terms, is the uncertainty of loss. This uncertainty encompasses doubt about the cause and outcome of a situation, uncertainty as to the occurrence of a loss in a situation, unpredictability about how a situation will unfold, and uncertainty about the chance of a loss occurring and which factors may influence that chance. In insurance, this uncertainty may be contextualized in the probability of damage or expected loss to an asset, or in the likelihood of an event occurring which in turn will lead to asset or livelihood loss. Across each of these cases, the components that determine risk for an insurance model include 1) level of uncertainty, 2) level of risk, and 3) peril and hazard. See also Climate Risks.

Risk Modeling

Risk modeling assesses the level of risk involved in insuring against a specific event or loss. Risk modeling accounts for the hazard to be insured, i.e., the estimated frequency and severity of the covered peril, the geographic exposure of the assets to be insured, and the vulnerability of these assets. Risk modeling is a highly complex process which requires both substantial internal resources and capacities as well as the considerable quality of historical data on the respective peril. In the context of climate and disaster risk finance and insurance, a lack of adequate data and risk modeling capabilities is often a large barrier to the provision of these services in developing countries.

See for example https://www.rms.com/products/models

Risk Pool

Risk pooling is a risk-spreading mechanism. In a risk pooling mechanism, risks are pooled across different parties and shared with multiple (re)insurers, wherein each (re)insurer assumes a particular portion of the cumulative risk. This enables (re)insurers to cover larger-scale risks (e.g., natural catastrophes) according to their risk-taking capacity. In the context of climate and disaster risk finance and insurance, risk pools allow countries to (i) pool risks in a diversified portfolio; (ii) retain some risk through joint reserves/capital; and (iii) transfer excess risk to the reinsurance and capital markets.

See further: https://www.bmz.de/de/zentrales_downloadarchiv/themen_und_schwerpunkte/klimaschutz/DFRI_G20_Brief.pdf

Risk Retention

Risk retention is an individual’s, party’s, company’s or country’s decision to take responsibility for a particular risk it faces (i.e., to retain the risk), as opposed to transferring the risk over to a (re)insurance company. Risks are often retained if it is believed that the cost of doing so is less than the cost of fully or partially insuring against it. If a particular risk is retained, losses from that risk must be paid out of an individual/party/company/country’s reserve funds. For this reason, it is essential to ensure that they can properly afford to pay for potential losses before they decide to retain particular risks.

Trigger

A trigger refers to the variable or index underlying an insurance mechanism: if a predefined threshold as defined through the trigger design is exceeded, the trigger prompts a coverage payout. Triggers can vary across each (re)insurance scheme according to perils, quality of data, needs for simplicity and transparency, and preference for basis risk reduction. For example, according to different needs, a trigger may be defined by a specific severity of loss, the occurrence of an event, the severity of an event, etc.

Underwriting

The process of assessing risks and potential losses to negotiate an insurance contract ultimately – including which risks will be covered, under what conditions, at what value, and for what premium.

Vulnerability

Vulnerability describes the susceptibility of exposed assets, people, or parties to injury or loss in a catastrophe. As a critical component of risk modeling, vulnerability refers to the ability of an exposed person or asset to withstand a physical impact through internal forces or structures, and thus resist or avoid fatality, injury, or damage. The vulnerability of assets to climate and disaster risk is therefore primarily driven by construction type (e.g., wood, masonry, etc.).

In the context of international cooperation for strengthened resilience against climate and disaster shocks, vulnerability is often used in a broader sense, i.e., including the exposure of a community or individual to natural disasters, particularly climate risks, as well as its capacity to recuperate and return to an acceptable level of functioning. Adequate insurance coverage is, therefore, a key factor to reduce the vulnerability in this broader definition.