Insurance Portfolio Diversification Through Bundling for Competing Agents Exposed to Uncorrelated Drought and Flood Risks

Worldwide, conflict over shared water resources is exacerbated by population growth, economic development, and climate change. In multipurpose water systems, stakeholders can face higher financial risks as a consequence of the higher costs or lower revenues arising from increased hydrological variability and recurrent extreme events. In this context, financial risk hedging tools able to bundle together the uncorrelated risks of wet and dry periods faced by different stakeholders may be an improved solution to both foster cooperation and manage the financial losses associated with extreme events. In this work, we explore the potential of risk diversification strategies, involving an index insurance contract solution, to simultaneously manage financial risk in a multipurpose water system prone to both drought and flood risk. Risk diversification can allow for reduced insurance premiums in situations in which the bundled risks are uncorrelated. Using an integrated operational and financial model, we characterize the financial risk associated with the water management policies and design a risk management strategy that bundles together the uncorrelated risk of drought and flood events. The approach is demonstrated using a case study on Lake Maggiore, a subalpine transboundary regulated lake whose management is controversial due to numerous and competing human activities. In particular, we focus on the ongoing conflict among the lake shore population, affected by flood risk, and the downstream farmers' districts, facing drought related losses. Results indicate that bundling uncorrelated risks from competing users is beneficial to both promoting insurance premium affordability and facilitating collaboration schemes at the catchment scale.