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.
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.