The advantages of parametric insurance

What is Parametric Insurance?

Conventional insurance indemnifies the policyholder for the loss it incurs from an insured event. Parametric insurance by contrast pays a fixed amount upon the occurrence of a triggering event. The amount payable can be based on a modelled forecast of the loss that the policyholder will incur. The nature of the product means that no loss adjusting need take place. As soon as a pre-determined threshold has been met, the policy is triggered and payment is made.

Conventional insurance indemnifies the policyholder for the loss it incurs from an insured event. Parametric insurance by contrast pays a fixed amount upon the occurrence of a triggering event. The amount payable can be based on a modelled forecast of the loss that the policyholder will incur. The nature of the product means that no loss adjusting need take place. As soon as a pre-determined threshold has been met, the policy is triggered and payment is made.

A parametric trigger can be anything, but is often set by reference to a measure of a catastrophic natural event which might lead to a loss or a series of losses. So, for example, hurricane cover might be triggered by wind speeds reaching a certain pre-agreed intensity in a specified location according to a trusted and verifiable provider of weather data. Earthquake cover might be triggered by seismic intensity, location, depth and radius data; while for drought and agricultural cover the parameters might be based on satellite images of the colour of the ground or volume and frequency of rainfall over defined periods.

Parametric products can cover risks that are not otherwise easily insurable, and allow for more scientific pricing of products that respond to specific isolated parameters, rather than the physical losses which might result from any number of a wide range of occurrences. Together with lower claims management costs, this makes lines of business commercially viable that were not previously. 

Data is key with parametrics and, as such, new indices based on datasets are regularly being researched and deployed, including from the Internet of Things (IoT). Provided there is a strong enough correlation between the index and the insured’s expected losses, it should be possible to define a parametric solution that offers speed and certainty of pay-out. Parametric policies are also deployed to build resilience in commercial settings.

For example, there are policies that cover food producers where demand for their produce is weather-sensitive, and providers of renewable energy whose output is reliant on weather conditions. In September 2017, both AXA and Chubb Europe launched parametric policies which automatically pay insureds a fixed sum if their flights are delayed by a certain amount of time. Other policies are available to those involved in logistics and hospitality, and parametric solutions can be used to provide speedy interim payments for business interruption.

Parametric policies can also be offered at a microinsurance level; sold directly to the consumer via mobile technologies, or as an add-on to existing microfinance services. Pioneers in this field include AXA and also Allianz, which in 2015 provided microinsurance to 45 million people in eleven countries in Asia, Africa and Latin America, including some on a parametric basis.

Parametric Insurance offers speed and certainty

These traits are particularly useful in developing countries where it is far more effective to respond before a loss event has turned into a humanitarian and economic crisis, with lives and livelihoods at severe risk and a nation’s development potentially put back years. Because parametric payments do not require loss adjusting on the ground, payments can be made quickly to hard-to-reach insureds in remote locations, often via online payment platforms or through mobile phone networks.

Some key benefits of parametric insurance are speed, certainty of pay-out and the ability to plan ahead

Parametrics are also extremely useful where there are wide-ranging and hard to quantify losses, for example at the national scale. Reflecting this, to date, national and regional governments with shared exposures have led the way in using parametric insurance to distribute funds to member states in a risk pool.

Some of the earliest proponents of parametric insurance were the Caribbean nations which came together after the devastation wreaked by Hurricane Ivan to create a regional risk pool against severe weather, now known as the Caribbean Catastrophic Risk Insurance Facility (CCRIF).

The benefits of parametric insurance have been highlighted in CCRIF’s response to hurricanes Irma and Maria where the facility was able to pay out over USD 50 million to member countries such as Dominica, Antigua and Barbuda, and Turks and Caicos within 14 days. In contrast, it is estimated that relief funding from international development partners normally takes between four and 12 months to mobilise.

Prevention is better than cure

The economic benefits of early intervention are clear. The UK’s Department for International Development estimates that it would have cost just USD 5 million to contain the 2014 Ebola outbreak when it was first detected in Guinea, potentially stopping the outbreak becoming a pandemic and saving thousands of lives.

Donors ended up giving over USD 7 billion in aid for Ebola response and recovery.

Since then, the World Bank has developed the Pandemic Emergency Financing Facility, covering pandemic risk using an insurance instrument. Payments from the fund are made when certain activation criteria are met based on type of disease, outbreak size, growth and speed. The World Bank estimates that if the fund had existed in 2014 during the Ebola outbreak, the world could have mobilized USD 100 million as early as four months after the outbreak was confirmed and so accelerated the emergency response.

In November 2017, the World Bank announced it would be applying lessons learned from the pandemic facility to address other humanitarian crises.

Another fundamental benefit of parametric insurance for building resilience is that a policy can be triggered not by the calamity itself (such as crop failure or the resulting human impacts), but by its forebear (such as inadequate rainfall), which through funding early intervention can minimise wider human and financial impacts and costs.

For example, one parametric crop policy is triggered on satellite images of grazing land – where a lack of greenery or yellow land indicates the crop is failing. If funds can be made available promptly to a vulnerable region, resources can flow to feed both people and livestock before famine strikes and migration follows.

HOW DO PARAMETRIC DERIVATIVES AND INSURANCE PRODUCTS DIFFER?

Index-based parametric insurance operates in a similar way to certain well-established types of product in the derivatives market, such as weather based derivatives.

In fact there is an overlap: what is in essence the same instrument can in many cases be framed either as insurance (assuming the customer has an insurable interest, and the provider is authorised as an insurer) or as a derivative. Professionals with the expertise required to model exposure and design a trigger can and do move between the two fields, and a number of insurance groups have divisions that design and issue derivative instruments.

Insurance and derivatives can be used side by side: this is the case with the World Bank’s Pandemic Emergency Financing Facility for instance. Alternatively an insurer might issue a parametric insurance policy and hedge its exposure by purchasing a derivative, or pass the risk to the capital markets through Insurance Linked Securities (ILS) products.

Overcoming barriers to entry

As well as being well-suited to building resilience to natural disasters and weather events, parametric products can also help overcome some of the barriers commercial insurers can face when entering new and developing markets. For example, governments in developing markets may have concerns about international insurers competing with local insurers for standard business. These barriers tend to be less problematic when international players can demonstrate they are offering something unavailable in local markets.

Clyde & Co’s research, undertaken by its insurance teams globally, suggests that in many parts of the world regulators and legislators are rapidly getting to grips with the opportunities presented by parametric insurance. Many regulators are now very amenable to and supportive of their roll-out.

On the supply side, parametric insurance may provide a solution for issues of scalability. It is commercially viable for an insurer to offer crop cover to largescale industrial farms in, say, the US, France or the UK, where premiums are large enough to cover underwriting and claims management costs. In places such as India, however, where the majority of agriculture is through smallholdings, there are too many small farms and not enough premium income to make traditional models profitable. However, it is now increasingly feasible to cover these farms through parametric policies potentially sold direct to the farmer using microinsurance principles.

Parametric Insurance in action

Mexico is a pioneer in the use of parametrics. In 1996, the Mexican government created a national fund for natural disasters — FONDEN — to which it transfers budgetary funds for disaster relief and reconstruction efforts. FONDEN uses various financial instruments to support local states and entities in responding to natural disasters, including reserve funds and risk transfer solutions.

In 2006, FONDEN issued a USD 160 million catastrophe bond (called “CatMex”) to transfer Mexico’s earthquake risk to the international capital markets. It was the first parametric cat bond issued by a sovereign.

African Risk Capacity (ARC) was launched by the African Union in 2014. Designed to provide an immediate financial pay-out to nation state members if there is a drought, the pool started with four countries as policyholders. In October 2017 Sudan joined the ARC bringing the total number of member countries to 22.

Africa RiskView, a bespoke technical engine used by ARC interprets different types of weather data, including rainfall estimates and information about crops, such as soil and cropping calendars. This data is then converted into meaningful indicators for agricultural production and applied to vulnerable populations that depend on rainfall for crops and rangeland for their livelihoods. Africa RiskView then uses this information to estimate how many people may be affected by drought or deficit rainfall in a given season.

At the end of 2015, ARC announced a plan to double its insurance offering through a replica coverage initiative which allows international organisations to take out ARC policies that match those already provided directly to African governments, expanding participating countries’ coverage. More recently, in 2017, the World Bank developed the Pacific Catastrophic Risk Facility (PCRAFI), a risk insurance pool for five small Pacific islands. The project builds on shared experiences from the similar catastrophe risk pools in Africa and the Caribbean.

Find out more from our Resilience Expert:

Nigel Brook

Partner