Index-based Insurance to Mitigate Drought Financial Losses for Water Supply Sector

Mitigation and management strategies for extreme events become essential for the development and maintenance of society as these events become more frequent and intense. Drought management strategies have focused on structural measures, however, they are not sufficient to prevent water supply disruptions and economic losses. In this concept, adaptation plays the role of anticipating the adverse effects of extreme events and taking appropriate measures to prevent and minimize them. Thus,  insurance is a valuable adaptation tool to reimburse unexpected losses and prevent financial damage from turning into long-term economic damage. We simulated indexed insurance for the Cantareira Water Supply System, responsible for providing water to 5 million people in the São Paulo Metropolitan Region (SPMR). Our methodology comprises (1) characterizing the indexed variable, (2) calculating economic losses by event magnitude and, (3) estimating the premium based on low, medium, and high coverage levels. To find the optimal premium value, we generated 100 synthetic series of 30 years sample (3000 years) and assessed its losses probability. We found two years lag accumulated precipitation as the index variable and a daily direct loss of USD* 480,000.00 due to drought in the distribution reservoir. Our results show that each person should pay an annual amount of USD 0.43, 0.87, and 1.73 to obtain a drought coverage level for 3, 6, and 12 months (Low, medium, and high) respectively. These values correspond to 1.7, 3.4, and 6.7% of the annual fee paid by water users. The premium fee can be implemented in the water bills as a new strategy to pool the risk between users and prevent them from being exposed to surcharge fluctuations. As disruptions are difficult to remedy in a short-run basis, the index insurance has the potential to significantly reduce the costs of managing financial risk and disruptions. Given that extreme weather events will become more frequent and intense in the future, we recognize the critical importance of financial tools to mitigate losses as an additional solution for water resources management.

* Data are in constant 2020 U.S. dollars (USD1.00 =BRL 5.15)