While parametric insurance solutions provide rapid payout post-event, offering welcomed transactional speed and transparency, risk transfer mechanisms that are structured this way might be best-suited to covering direct and well-defined physical damage, according to Guillermo Franco, Global Head of Cat Risk Research at reinsurance broker Guy Carpenter.
Under a parametric insurance policy, payments are triggered when predetermined parameters are met, such as an amount of rainfall at a given location or hurricane windspeed for a certain amount of time at a specific location, ultimately removing the need for the traditional claims adjustment process, which can take a long time.
The result is that funds for recovery and rebuilding can typically be disbursed in a matter of weeks, which, in certain instances is far more suitable than waiting months and even years for the traditional claims adjustment process to complete.
“When evaluating the benefits of parametric insurance, the positive traits of speed and transparency need to be assessed against the cost of basis risk – the difference between actual losses and the recoveries received.
“When protecting specific physical assets this difference can have a dramatic impact. Picture the extreme case of a small event causing large damages without triggering any payment, leaving the policyholder with a shortfall. Covering this type of direct and well-defined physical damage might not be the best-use case of parametric,” explains Franco.
It’s an interesting point, and one that’s often discussed in the reinsurance, but also the insurance-linked securities (ILS) sector and more specifically the catastrophe bond space where parametric trigger structures are utilised to provide some of the world’s most vulnerable with protection against natural catastrophe events.
While basis risk certainly exists when using a parametric structure for physical damage, for poorer parts of the world it still provides rapid payout post-event which is vital to both effectively and efficiently rebuild societies and economies.
An example of this can be seen with member countries of the CCRIF SPC, a risk pool mechanism for vulnerable regions which utilises parametric insurance to protect against extreme weather events. So far, the CCRIF SPC has made 41 payouts totalling $152 million to member governments following events, with the money reaching those in need in as little as two weeks from the event date in some cases.
While there is a clear benefit for parametric insurance to tackle some of the more tangible risks, especially when considering perils and regions that aren’t so well understood or modelled as say U.S. wind or Japanese typhoon, Franco suggest that parametrics might be more suited to protecting the more intangible.
“Instead, consider the possibility of protecting more intangible losses such as those related to contingent business interruption, utility or transportation network failure, emergency response or supply chain. As those losses are much harder to evaluate than physical damages to a building, an insured may be satisfied with an approximate recovery that arrives fast, rather than waiting years for an adjustment outcome that, even after much effort, may remain questionable.
“Post-event situations are time-sensitive and a combination of adverse circumstances can trigger a secondary disaster. Businesses and governments should contemplate basis risk as a manageable cost they might be willing to accept in exchange for the speedy availability of funds,” said Franco.
Parametric risk transfer solutions are just one of the many innovative tools that insurers and reinsurers can use to help provide protection to those that really need it, ultimately increasing penetration levels and subsequently lowering the world’s protection gaps (disparity between economic and insured losses post-event).
But as suggested by Franco, it’s important that companies understand specific regions and perils in order to obtain a comprehensive view of the risk, which in turn should result in the most effective structures being used in the right places, helping to create a more resilient world to the impacts of natural catastrophe events and beyond.
