Mitigating Drought Financial Risk for Water Supply Sector through Index-Based Insurance Contracts

Abstract

Drought management strategies have primarily focused on structural measures, which are insufficient to prevent water supply disruptions and economic losses. In this concept, adaptation entails anticipating the negative financial consequences of extreme weather events and taking appropriate measures to prevent and mitigate them. As a result, insurance is a valuable adaptation measure for compensating unexpected losses and preventing financial damage from becoming long-term economic damage. We simulated indexed insurance for the Cantareira Water Supply System (CWSS). The system is responsible for providing water to 7.2 million people in the Metropolitan Region of São Paulo (MRSP). Our methodology consists of three steps: (1) describing the indexed variable, (2) computing economic losses depending on event magnitude, and (3) evaluating risk premiums for low, medium, and high coverage levels. According to our findings, an annual fee (premium) of USD 0.43, 0.87, and 1.73 should be charged per person to obtain drought coverage for 3, 6, and 12 months (low, medium, and high levels), respectively. These values account for 1.7 %, 3.4 %, and 6.7 % of the annual costs paid by CWSS-supplied users, accordingly. The premium fee can be incorporated into water bills as a novel technique to pool the risk between supplied users and the utility, thereby protecting them against surcharge fluctuations.