Climate change is increasing the risks of weather-related disasters in many regions around the world. This has an adverse socio-economic impact on households, farmers and small businesses. Some strategies for effectively managing climate related disasters include index based insurance products, which are increasingly offered as alternatives to traditional insurance, particularly in low-income countries. However, the uptake of index insurance remains low, which can be partially attributed to the inherent problem of basis risk. This review assesses the problem of basis risk that occurs when insurance payouts depend on an index that is imperfectly related with actual losses experienced by the insurance policyholder. Special attention is paid to the design of the index, quality and sampling data, the estimation of basis risk and its influence on insurance demand, and index-insurance supply. The paper concludes with several policy recommendations including the need for a systematic approach to quantify the magnitude of basis risk, to inform index design with participatory approaches, to offer index insurance through existing risk sharing networks. Moreover, we recommend to improve policyholders access to information about their risk and measures they can take to limit risk, create an enabling environment for a wellfunctioning insurance market, and lastly to have an integrated approach that incorporates insurance with other mechanisms that reduce basis risk.

Introduction

Climate change can have major impacts on human society through increasing the magnitude and frequency of extreme weather events that can trigger a natural disaster or emergency (IPCC 2012). The economic losses resulting from natural disasters have already increased worldwide and are expected to increase further in the future (IPCC 2014). For instance, the economic costs of natural disasters have increased from $25 billion per year in the 1980s to $ 175 billion in 2016 (Munich Re 2017). These trends in natural disaster risks highlight the need to develop policies that limit, and help society cope with, the impacts of future natural disasters. It has been suggested that multi-sector partnerships can be effective to encourage adaptation to climate change risks, which consist of collaborations between different private or public agents and institutions (e.g. Bowen and Ebi, 2015). Establishing such partnerships in financial compensation arrangements for climate risks, such as insurance, is important since these can aid in managing natural disaster risks and can decrease the immediate and long-term financial impacts associated with natural disasters (Kunreuther, 2015). Recent research has shown that climate risk insurance is a priority area for many countries with at least 38 countries mentioning climate risk insurance approaches in their Nationally Determined Contributions (NDCs). In addition, another four countries feature the topic in their more elaborated National Adaptation Plans (NAPs). These countries represent some 4 billion people including some of the world’s extreme poor (Kreft et al. 2017). Index-based insurance products were first proposed as alternatives to traditional claimbased insurance starting in the 1950s when the U.S. started to experiment with area-yield index insurance (Barnett et al. 2005). Approximately fifty years later, weather and satellite based index insurance products are increasingly being piloted in both developed and developing countries.