Triggered: Parametric insurance and natural catastrophe losses

By Daryl Angier   |   March 2019   |   13 minute read

Parametric or index-based insurance is an innovative solution for corporate clients looking for balance sheet protection that traditional insurance products can’t provide. 

Parametric structures have been used with catastrophe bonds for the reinsurance market for over 30 years now. Since the 1990s, advances in data analytics, computing power and the need for product innovation to cover a broader range of risks have driven an increase in discussions with corporate buyers around insurance products that rely on a parameter or index threshold as a trigger for the policy. These products were first used only by the largest corporate and public entities to deal with major black swan events such as hurricanes and earthquakes. In recent years, parametric products have evolved in sophistication and pricing such that even mid-market and smaller corporate clients are making use of them. Some insurers have even experimented with retail products for consumers in some jurisdictions. For brokers looking to expand their toolbox, parametric insurance products are an innovative solution in a world where weather-related natural catastrophes appear to be increasing in frequency and severity—and potentially driving a hardening market.

How does parametric insurance work?

The key differences between parametric—or index-based—insurance solutions and traditional indemnity-based insurance products is how a claim payout is triggered and how much is paid. With indemnity-based products, an insured receives a claim payment based on physical damage to an insured asset that they own. In simple terms, the trigger for the payout is the damage and the amount paid out will be based on that damage.

Parametric insurance solutions, on the other hand, are triggered by a pre-defined event—a parameter—and the payout is predetermined, regardless of damage. Parametric solutions are structured based on these two elements:

1) A triggering event. Weather events occurring within a specified geographic area are by far the most common parametric trigger. Examples are a storm exceeding Category 3 on the Saffir-Simpson Hurricane Wind Speed Scale, rainfall or snowfall exceedance or deficit and others. Earthquake epicentre location and/or shake intensity are also important parametric triggers.

The parameter must be an objective measure that is transparent and consistent to avoid moral hazard on the part of the insurer and the insured. Quick measurement is also essential to ensure prompt payout. For these reasons, parametric triggers rely on reporting from trusted independent agencies such as Environment Canada or the United States Geological Survey (USGS), among others.

However, an insurable trigger can be anything from movement on a market index, to crop yields to power outages and even reduced passenger seat miles for an airline, as long as the event meets the following criteria: a) it is fortuitous, i.e. happening by chance rather than by design, and b) it can be modeled.

2) A payout mechanism. If a pre-agreed parameter or index threshold is reached or exceeded then the policy will pay out a specified amount, regardless of what physical losses the insured may have sustained. Because there is no need for loss adjustment, the payout occurs quickly—usually within 30 days.

Quick payout is one of the major advantages of parametric solutions, especially for corporate clients and public entities dealing with the immediate aftermath of a catastrophe.

“Particularly with a widespread area that’s devastated from a hurricane or an earthquake, loss adjusters may be few and far between, contractors are stretched, building materials are stretched,” says Robert Nusslein, Head of Innovative Risk Solutions Americas for Swiss Re Corporate Solutions. “So it can be very difficult to get a claim paid quickly and get to the front of the line to get product and contractors in to make repairs,” with traditional indemnity-based insurance.

Over the last several years, insurers offering parametric solutions have fine-tuned payout mechanisms to reduce the basis risk inherent in the first generation of parametric products. First generation products are commonly referred to as “CAT (i.e. catastrophe) in a circle” or “CAT in a box.” Examples of this basic structure are the requirement for the eye of a hurricane to pass through a circle with a 40 km radius around an insured’s property, or have the epicentre of an earthquake occur within a similarly defined circle or box.

WHAT IS BASIS RISK?

Basis risk is the risk that an insurance product will not perform or respond to the event it is designed to respond to when the event occurs. With parametric products, basis risk refers to the near-miss factor. For example, an insured has a parametric policy for a hurricane passing through a 40 km radius around their property, a hurricane occurs and causes substantial damage to their assets, but the eye of the hurricane passed 50 km away and so the parametric policy is not triggered. Basis risk can be particularly acute when structuring parametric products to deal with earthquake.

Basis risk is not unique to parametric products. The terms and conditions, exclusions, limits and sub-limits that are found in any traditional indemnity-based product also represent forms of basis risk.

In this scenario, the eye of a hurricane could pass just outside the circle, or the quake epicentre may be located outside the box, and therefore fail to trigger the parametric policy. Nevertheless, the insured may still have suffered damage from high winds or ground shaking. In response, insurers have created more nuanced structures such as measuring ground shake intensity at certain locations or windspeed and/or rainfall exceedance within a defined area. Additionally, payout mechanisms can be structured in a step fashion rather than all-or-nothing. For example, if windspeeds within the circle exceed 160 km/hr the insured gets a payout of 50% of the limit, or 75% of the limit if they exceed 240 km/hr and so on

How is parametric insurance used?

Experts agree that parametric insurance solutions are a useful supplement to traditional insurance programs but definitely not a replacement for them. Parametric products are most useful for responding to loss of income and extra expenses that may result from a catastrophe. This is especially true when the insured has suffered little or no physical damage to their own assets, which means that the business interruption portion of their traditional property insurance policy will not respond. The quick payout from parametric products can also provide an important infusion of cash for emergency assistance and other needs at a time when a corporate or public entity’s revenue streams may have been turned off due to a disaster.

First used as a form of catastrophe bond for the reinsurance market, parametric insurance structures started gaining traction among large corporate and government buyers in the 1990s and early 2000s, according to Balz Grollimund, Head of Treaty Underwriting, Canada & English Caribbean for Swiss Re.

“In Japan—one of the first and still one of the biggest markets for parametric products—it was very difficult for large corporates, such as semiconductor plants and car manufacturers, to purchase coverage for business interruption following an earthquake. Parametric products helped meet a need that was unmet by traditional insurance products,” he says.

On the government and public entity side, Grollimund notes the Caribbean Catastrophe Risk Insurance Facility (CCRIF SPC) as an important early adopter of parametric-like insurance based on modeled losses for use in disaster relief efforts following hurricanes and earthquakes.

In North America, Swiss Re Corporate Solution’s Robert Nusslein points to the year 2005—the year of Hurricanes Katrina, Wilma and Rita—as a watershed moment for interest in parametric solutions.

“In 2005, we started seeing a lot of concerns from risk managers that traditional insurance, while valuable, wasn’t really meeting their needs completely. What we’re seeing with these natural catastrophes is clients may have little or no damage but the area around them is devastated. The infrastructure is impacted so they have a difficult time shipping goods or receiving goods from a port that is disrupted. That’s typically not covered because it’s not an insured asset that they own. But it still disrupts their business,” he says.

Nusslein says interest in parametrics has peaked again recently due to Hurricanes Harvey, Irma and Maria in 2017 and Florence and Michael in 2018.

What industries are using parametric insurance and how?

A number of different industries are now using parametric solutions with many different triggers to protect their balance sheet and provide a liquidity infusion that they otherwise wouldn’t be able to finance on their own. Examples include:

>Agriculture. Matthew Zuccato, Alternative Risk Solutions National Practice Leader for Marsh Canada, says common concerns in this area are the obvious ones such as storm, frost, drought and other weather events that can damage crops.
>Construction. Both severe heat and extreme cold can delay completion of projects. “You have to look at the contractual provision between owner and contractor and who shifted that risk of a delayed startup to whom,” says Swiss Re Corporate Solutions’ Nusslein. “Is it the contractor paying liquidated damages for late delivery? Or is the owner taking that risk and relying on an asset being up and running and then can’t derive revenue from it due to weather related delays?”
>Utilities. Nusslein points to the fact transmission and distribution lines are uninsurable for the most part. Parametric products can provide an alternative to finance expensive repairs following major catastrophes.
>Hospitality. Hotels in storm-prone regions are major purchasers of parametric products. They are used to cover significant loss of income from bookings that may occur following a major event.
>Ports and airports. These are usually owned by a public entity such as a municipality or regional government. If a port is damaged in a storm it can mean a significant loss of income for the entity that owns it.
>Municipalities. Major cities like Toronto and Montreal may need to purchase a parametric product to deal with an excess of snowfall over the winter that may drain a city’s snow removal budget before the winter is over.
>Mining. Marsh Canada’s Zuccato explains that significant precipitation into open-pit mines or washing to road access can render them inoperable and cause a significant business interruption loss.

In addition to these industries, parametric solutions have spread to buyers in industries that may not initially appear to be catastrophe exposed. Swiss Re Corporate Solutions’ Nusslein says he has seen a great deal of interest from private equity firms purchasing loan portfolios and real estate assets at distressed prices that want to hedge their investment over the holding period.

Similarly, Michael Gruetzmacher, Managing Director of the Alternative Risk Solutions Team at Aon, says tech companies in California are interested in parametric covers to help their people in the event of an earthquake.

“What if they have to spend a lot of money on employee assistance to get people back on their feet? Tech companies have invested a lot in their engineering and they feel they’ve pretty much taken care of their own assets. It’s the stuff outside of their control that they’re concerned about,” says Gruetzmacher.

When retaining the risk is not an option

The unifying factors in the above use case scenarios are that the risks involved are either uninsurable through indemnity-based products or are simply too large for an organization to retain the risk on its own. A good example of this is using parametric solutions for deductible in-fill for earthquake and other perils.

“There are public entities in the United States such as state university systems with anywhere from $20-$50 billion in insured value,” says Swiss Re Corporate Solutions’ Nusslein. “They may have deductibles of 3%-5% of that value. Therefore the amount of risk they are retaining is enormous. So they question the value of traditional nat cat covers and are gravitating to parametrics.”

“You could still have a large retention with some reinsurance through a parametric type solution,” says Marsh Canada’s Zuccato. “But it’s really about trying to mitigate revenue volatility and protect the balance sheet.”

Challenges with parametrics

For insurers that want to offer parametric insurance solutions, the first challenge is gaining regulatory approval in the jurisdictions where they want to offer the product. Parametric products function similarly to derivatives, except unlike derivatives, there is an insurable interest involved. Parametric products usually require that the insured complete a simple certification of loss stating that they incurred losses equal to or greater than the amount that they were paid as proof of the insurable interest.

“Every regulator will have their view, which may differ considerably between jurisdictions,” says Swiss Re’s Grollimund. “There are countries where they haven’t had any parametric products in place so there’s no opinion by the regulator yet.” Indeed, some companies in Canada are currently working through the regulatory approval process in order to offer them.

In terms of the functioning of the product, experts agree that the biggest challenge is obtaining reliable data to model the risk the insured is concerned about. As far as things have come in the last several years, not every risk can be accurately modeled yet. Marsh Canada’s Zuccato points to a Canadian example.

“Some reinsurers are looking at satellite imagery as a proxy to understand the triggering of losses for a difficult to index risk location, such as a wildfire type of event. There are some locations that are difficult to get to or get data from. As time moves forward those challenges are beginning to reduce.”

Cost is another concern for buyers. Parametric products may appear expensive next to indemnity-based products with similar limits. Aon’s Gruetzmacher says a simple rule of thumb for a parametric cover is a premium between 2%-5% of the policy limit. Therefore a parametric policy with a $50 million limit might have a premium ranging from $1 million to $2.5 million, whereas the premium for an indemnity-based product with a similar limit would be a fraction of that amount.

“The important point, though, is the traditional product will only cover property damage and business interruption arising from the property damage. Whereas the parametric product is going to apply to any economic costs coming out of that event,” he says.

But the biggest challenge of all may be educating people—clients and brokers included—about how parametric products work.

“It’s not as easy as saying ‘If you have cancellations you’ll get paid,’” says Swiss Re’s Grollimund. “It’s difficult to market because you have to explain what it is and does and does not do. There’s often an inherent mismatch between the payouts and what the buyer wants to get.”

Opportunities for brokers and customers with parametrics

While experts agree that the scope of opportunities for parametric products may remain limited to niche solutions, those opportunities continue to expand nevertheless.

“The real value of the parametric trigger is it expands the solution set,” says Aon’s Gruetzmacher. “It creates an opportunity to think more creatively about how do we use insurance capital to solve problems.”

For example, parametric products can be a tool to help brokers open up conversations with a broader range of stakeholders in an organization, says Marsh Canada’s Zuccato.

“It’s always great to work with not just the insurance buyer at an organization but also the enterprise risk management team that has developed a holistic set of risks that may fall outside of insurance and will be non-insurable. So you can start to look at structuring solutions for those risks as well. There are many organizations where the risk departments and insurance departments have the potential to improve their alignment.”

The fiscal realities of the traditional insurance market may be another driver of opportunities for parametric products.

“As we’re seeing more catastrophic events and different types of seasonal weather, it is certainly bringing these types of solutions to the forefront,” adds Zuccato. “As these events continue to happen and perhaps get worse, it may affect traditional insurance appetite as well as its pricing where parametric solutions will more and more become part of the normal conversation.”

Gruetzmacher agrees that the potential for a coming hard market and the tightening of terms, conditions and limits that may go along with it may open up even more opportunities for parametric solutions.

“The traditional insurance market will be more volatile, given that it is driven to a large extent by insurers’ balance sheets. But parametrics should be less volatile, because it’s based on what’s the probability of the event. As long as we can put the data together to describe that.”

ADVANTAGE Monthly trends papers

This paper is part of an open online library of ADVANTAGE Monthly trends papers, published by the CIP Society for the benefit of its members and of the p&c insurance industry. The trends papers provide a detailed analysis of emerging trends and issues, include context and impact, and commentary from experts in the field.

The CIP Society represents more than 18,000 graduates of the Insurance Institute’s Fellowship (FCIP) and Chartered Insurance Professional (CIP) programs. As the professionals’ division of the Insurance Institute of Canada, the Society’s mission is to advance the education, experience, ethics and excellence of our members. The Society provides a number of programs that promote the CIP and FCIP designations, continuous professional development, professional ethics, mentoring, national leaderships awards, and research on the issues impacting the p&c insurance industry in Canada.