Parametric Insurance for Drought and Market Impacts Mitigation in the Hydropower Sector

Abstract Recent decades have seen rapid changes in water resources and economic conditions worldwide, with significant impacts on hydropower profitability and feasibility. Growing interest has then emerged in financial risk‐hedging tools, especially parametric insurance, to help coping with climatic and market uncertainty. However, the role of multivariate indices and their interaction with different insurance contract types remains largely unexplored. To address these challenges, we develop a framework to design and evaluate parametric insurance schemes for the hydropower sector. Numerical experiments applied to the Lake Como Basin (Italy) provide a comprehensive evaluation of multiple contracts and indices, while analyzing the viewpoints of both insurers and clients. Results show the importance of explicitly introducing electricity prices into multivariate indices. Moreover, we challenge the perception of insurance design as an adversarial process, by highlighting the importance of collaboration between stakeholders. The most frequently adopted standard contract provides mediocre performance for clients but the highest returns for insurers, while binary contracts require lower capital reserves by insurers. Collar contracts instead are found to be the most cost‐effective option for clients while providing the best risk mitigation, at the expense of higher uncertainties for insurers. For this reason, we propose an additional “hybrid” contract, allowing better performance than the standard and binary, but with lower trade‐offs than the collar. Contract selection emerges as a nontrivial process that requires careful consideration of market and competition dynamics. Ultimately, our results offer guidance to hydropower companies and insurers in the design and evaluation of parametric insurance worldwide.