Evaluating Soverign Disaster Risk Finance Strategies: A Framework
October 2017, Geneva Papers on Risk and Insurance
Unpacking Basis Risk
August 2017, RMS
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Last Updated 7/25/18
The term parametric insurance describes a type of insurance contract that insures a policyholder against the occurrence of a specific event by paying a set amount based on the magnitude of the event, as opposed to the magnitude of the losses in a traditional indemnity policy. An example is a policy that pays $100,000 if an earthquake with magnitude 5.0 or greater occurs. The amount of payment, the parameter, and a third party responsible for verifying that the parameter was triggered must all be specified in the contract. The third party will usually be a government agency, for example earthquake magnitude could be determined by the measurement issued by the National Earthquake Information Center. There will often be a tier of third party verifiers as a contingency plan in case the primary agency is incapacitated. For example, if the earthquake damages the sensors of the National Earthquake Information Center so that their issuance of an official magnitude is delayed, another agency’s reading will be used so that payment is still timely.
Parametric insurance today plays a significant role in the market for disaster insurance. This type of contract is attractive because the elimination of the claims adjustment process allows money to reach policyholders much faster. Payment can be made in a matter of weeks with a parametric contract verses months or years with a standard indemnity contract. For victims of natural disasters, the speed at which payment is made can have a significant impact. Firms insuring against business interruption risk, government agencies responsible for disaster response, and non-governmental organizations (NGOs) providing assistance all benefit from receiving payout faster because resources can be deployed more rapidly at the most critical time, right after the disaster has struck. The most comprehensive analysis on this benefit can be found in a study commissioned by the United Kingdom’s Department for International Development (DFID) and completed by the risk modeling firm Risk Management Solutions (RMS). It concluded that because faster availability of funds can accelerate disaster response and deescalate losses, payments from a parametric insurance policy can be 3.5 times as effective as delayed payments from aid.
There are many notable examples of this type of insurance, the utilization of parametric triggers to provide faster liquidity being a defining characteristic of each. The Caribbean Catastrophe Risk Insurance Facility (CCRIF), a catastrophe fund for primarily Caribbean governments that insures against hurricanes and earthquakes developed in 2007. The African Risk Capacity (ARC) functions similarly by pooling funds from African Union member states to insure against climate risk, utilizing Africa RiskView, a satellite weather surveillance system, to determine the magnitude of the parameters. In October 2017 SwissRe won the Hong Kong Insurance Award for Most Innovative Product/Service for its newly developed typhoon warning parametric insurance product, Insur8. The product is designed to mitigate business interruption risk by paying a fixed sum to Hong Kong businesses in the event of a typhoon warning signal of 8 or greater. In March 2017 AXA launched AXA Global Parametrics, an arm of its business providing parameter-based insurance against many climate risks. RMS offers “Paradex,” a service that currently models and indexes hurricane and earthquake risk in the United States, typhoon and earthquake risk in Japan, and windstorm risk for parametric coverage.
The most obvious downside to a parametric insurance policy is basis risk. The economic losses of the insured could differ by any margin from the amount of coverage, or the insured could have losses without the parameter being triggered. Accurately structuring and pricing the product requires a firm understanding of the exact exposures of the policyholder and carefully selecting the most appropriate parameter to fit those exposures. This type of issue was brought to light after a drought in Malawi during the 2015-2016 agricultural season. Malawi had purchased parametric agricultural insurance through the ARC, but many farmers had since shifted to a different crop with a shorter growing cycle, more exposed to the drought, than the model originally assumed. A payout was not originally triggered because the losses were not estimated to be widespread. After an investigation and recalibration of the model, a payout was triggered. As geographic modeling capabilities increase, more granular geographic zones should lessen basis risk. For policyholders that are especially concerned with basis risk, potential exists for the offering of a parametric insurance product with a higher premium that biases the basis risk towards overpayment.
There are other benefits or potential applications of parametric insurance currently being explored. Since the amount of payment is unaffected by the total loss, the insured still has an incentive to minimize their losses. This reduces the insurance company’s exposure to the problem of moral hazard. The risk of insurance fraud is also reduced for larger contracts, because payment is standardized and the event is large scale and independently verified. Parametric insurance has the potential to work alongside standard indemnity policies in the case of a parametric policy that pays an amount equal to the deductible or a hybrid policy that pays an immediate sum based on the parameter and proceeds with the claims adjustment process so that indemnification is still the end result. An NGO could use donations to cover the premium on a parametric insurance policy to more closely match the availability of funds with their “liabilities” during a catastrophe. The standardization of the policies allows risk to be more effectively transferred to capital markets via the growing market for insurance-linked securities. More parametric disaster insurance policies that payout based on the forecasted magnitude of weather events could develop in order to further increase payment speed. Parametric insurance is also driving the growth of microinsurance, a term which describes small scale insurance policies offered in developing markets. Traditional indemnity policies may have otherwise been unprofitable or prohibitively expensive to these consumers due to the higher administrative costs associated with the claims adjustment process.
Few jurisdictions have regulation specific to parametric insurance policies, so in general they exist under the same regulatory framework as traditional policies. This can create hurdles in some jurisdictions where principles of indemnity or contingency are mentioned in the existing insurance legal framework, for example in some jurisdictions in India and South Africa policyholders are required to prove that a loss has occurred which can slow down the payment. Parametric insurers are subject to the same solvency and market conduct oversight.