The world is witnessing a wave of short- and long-term trends, destined to drastically shape the future of our society and planet. Energy transformation, supply chain optimisation, digitalisation, and ESG-related requirements are some examples of how a fast-changing environment poses a wide range of challenges for those involved. Whilst obstacles create opportunities and investments, both the public and private sectors are faced with extreme uncertainty on the one hand and a need to act on the other.
Customers are facing increasingly complex risk management challenges and deserve an innovative risk partner that combines knowledge, agility, and creativity to help address those challenges. The following examples span industries, geographies, and technologies, but they are all designed to make our customers – and the world – more resilient.
Climate change is posing threats to society and economies. This adds a layer of risk and uncertainty to supply chains that are already under pressure, not least from COVID-related staff shortages. Delays in areas from manufacturing to transport as the global economy looks to recover from COVID-19 mitigation measures are also having a sizeable impact. As businesses become ever more interconnected, disruption and damage in one part of the world cause ripples that are felt globally.
Faced with increasing risks and greater costs and losses, businesses need to identify and rethink the weak points in their supply chains. Who are their main suppliers of goods and services? Are there any second-tier suppliers that may source solely from primary suppliers? What do they provide and what are the revenues associated with this? Products exist that can help provide answers to some of these questions.
The modern client is savvy and aware of his/her business risk situation and possible solutions. With the current hard insurance market and recovery from the pandemic, risk managers are battling to protect their risks, allowing them to make the tough decision to carry more risk for themselves. The impact of a hard insurance market and Covid-19 has shown clients the need to truly understand risk management and how insurance works. Viable alternatives such as parametric solutions are considered alternative risk transfer solutions.
What is Parametric Insurance?
Parametric (or index-based) solutions are a type of insurance that covers the probability of a predefined event happening instead of indemnifying an actual loss incurred. It is an agreement to make a payment upon the occurrence of a triggering event, and as such is detached from an underlying physical asset or piece of infrastructure.
While traditional indemnity insurance pays out a claim based on the value of the loss suffered, parametric insurance policies pay out only upon the occurrence of specified events (e.g., weather events). The amount paid out is not based on the cost of the actual loss incurred but rather on the size of the event. Wind speed, earthquake magnitude, water levels, and amount of rainfall are the most common examples. However, predetermined trigger events don't have to be weather-related risks; business interruption caused by problems in the supply chain can also be a trigger.
Example: Most consumers are familiar with insurance that reimburses them for the damages they sustain or the costs they incur after a specified incident. After a car accident, insurance will reimburse the costs of repair. In case of a fire, homeowners insurance pays the cost of fixing the damage. For these insurance policies, the insurance company must know the exact cost of loss. For damage to a home, for instance, the insurance company sends a loss adjuster to assess the damage. This common understanding of insurance is referred to as indemnity insurance. In parametric insurance, the amount of pay-out is dictated by an objective measure of the causal event, instead of the damage sustained. For example, pay-out could be related to wind speed in a location or the height of a river above flood stage. The indicator that determines the pay-out is referred to as the trigger. Since the pay-out is not linked to property damages, it is a useful approach for covering a wider range of disaster losses, such as business interruption.
Parametric insurance emerged from the need to respond to the increasingly exacerbated climate crisis and its accompanying risks. This new solution has since then established its innovative position in the changing insurance landscape, meeting client needs to maintain natural risk covers and optimize their insurance budget in a hard market. With the advance of new technologies and data, parametric insurers can offer extremely modern models rather than solely rely on historical claims.
Parametric insurance is elegant in its simplicity and the cover consists of two key components - a triggering event, and a pay-out mechanism – which together determine the scope of the policy, pricing, and the conditions under which the insured receives financial reimbursement.
The mechanism of parametric insurance can be explained in three steps:
- The definition of ‘parameter’ is agreed upon. A parametric insurer, a broker, and a client define the coverage based on historical data, potential risk, and other relevant aspects. As a result, each client gets their customized insurance program depending on the degree of exposure to threats, and their available budget.
- Cutting-edge technologies are employed to monitor the evolution of the on-site threats and see if the threshold is met in near real-time 24/7. Data sources such as IoT, satellite imagery, stationary sensors, radar, or sonar data, will be grafted onto the insured area. The data collected from these tools is integrated and interpreted with machine learning algorithms, image recognition techniques, or advanced statistics that are constantly generated and updated.
- When the threshold is met or exceeded, clients receive the pre-agreed indemnity in just a few days.
What defines parametric insurance is the precise protection that it offers. When a predefined event occurs (a flood, wildfire, or earthquake), parametric insurance pays out rapidly and transparently. The ability to respond immediately to natural disasters or weather-related losses is the key to mitigating detrimental knock-on effects and getting you back to normal business quickly. This requires quick and flexible risk management. Parametric products complement traditional insurance coverage for policyholders aiming to reduce their risk exposure and can cover risks that have traditionally been uninsurable. Globally, capital markets have successfully structured several placements for weather-related indemnity where such risks are not insured or under-insured.
Parametric covers can be designed to cover both specific catastrophic losses and frequency losses (e.g., business interruptions caused by a hurricane). As such, it is important to consider how the combination of traditional indemnity policies can work together with parametric solutions to achieve the best results.
Parametric covers can be especially useful when there is a lack of capacity or appetite from traditional insurance markets, especially for risks that are typically underinsured or uninsured, or where the impact of the event is related to business interruption losses that are greater than the direct costs of the loss or damage of physical assets. For example, for shipping companies, the direct physical effects of decreased water level may be non-existent, but the costs of business interruption and associated revenue loss are significant. A parametric cover based on the water level would help protect against lost revenue in this instance.
Parametric insurance provides customers confidence when it comes to liquidity and speed of pay-out where predictive loss methods fall short and offers benefits beyond expanding coverage. It also reduces complexity of the loss investigation process and provides greater certainty of loss payment recovery compared to traditional insurance products.
Parametric insurance is also being used for a variety of risks beyond climate-related weather disasters. Advances in big data analytics, computing power, and modelling processes are building more customized parametric insurance against other specific risks such as cyber, data breach, or even reputational damage.
The African context for parametric insurance
The impact of climate change sees Africa lose up to 15% of its gross domestic product per capita, every year, suggesting there’s an urgent need to expand the use of alternative risk solutions - such as parametric insurance - to help more countries effectively navigate the changing climate.
Agricultural production is vital to food security with smallholder farmers accounting for more than 60% of the economically active population of Sub-Saharan Africa. Only 6% of cultivated land is irrigated, most of which is in five countries and the increase in droughts, floods, heatwaves, and cyclones are threatening livelihoods and lives.
Parametric insurance can ease the financial blow of natural disasters on vulnerable nations. It uses satellite data to determine pre-emptively the impact of a disaster and the required compensation, in the form of an insurance pay out, when that disaster strikes. This enables governments to deploy emergency relief quickly, instead of waiting for months until damage assessments are complete.
On the African continent, parametric insurance is still new but slowly gaining momentum. The African Risk Capacity (ARC) Group, a specialised agency of the African Union, has been making inroads since 2014, working with governments to create awareness, while motivating the evolution of the appeals-based model to parametric insurance.
ARC also helps these governments improve their planning, preparedness, and response to natural disasters. Rapid urbanisation in under-resourced towns and cities has resulted in African countries’ disaster risk profiles evolving to include both rural and urban challenges. This, compounded by the prohibitive cost of insurance, means most African countries remain vulnerable and ill-prepared for weather calamities.
ARC Group’s financial affiliate, ARC Ltd., currently provides parametric insurance to 35 sovereign member states across Africa, to effectively fight climate change. One of the greatest challenges as expressed by ARC Ltd is forging a better understanding of how parametric insurance fits into disaster risk management while addressing the cost of insurance premiums.
Through ARC Ltd.’s sovereign risk pooling, countries are grouped, and the cost of their premiums is reduced. This is due to the risk being shared by the pool, as not all countries will experience natural disasters simultaneously. The funds go into an insurance coffer and are therefore available when needed. ARC Ltd. paid out ~US$125 million in claims, since inception, half of which was to a single pool in 2021, making the value of Africa’s participation in parametric insurance undeniable.
Pay-outs assist governments to support their affected populations quickly, helping them rebuild and recover from the effects of a drought or tropical cyclone and ensuring they have the means to bounce back swiftly instead of resorting to negative coping mechanisms. The ARC Ltd. risk transfer and risk pool solution is the only affordable disaster-risk system on the African continent
Current landscape for parametric covers
The first parametric products have been around since the late-1990s and were developed by commodities traders as well as energy companies. (e.g., AXA, Swiss Re, and Munich Re). Currently, parametric insurance solutions are mostly used in the reinsurance space around catastrophe risks, though usage expanded to other sectors such as aviation, special events, and projects to protect against pure financial losses resulting from forces outside of an insured’s control.
Insurance buyers considering a parametric solution face several challenges that must be reconciled before moving forward. The data demands of parametric solutions are different than for traditional insurance and since coverage tends to be wider, it may be more expensive. Therefore, a buyer must have a strong understanding of the organization’s business model and must be able to develop financial details and significant amounts of data to ensure that the approach will benefit the organization.
Parametric policies are rising in considering the virtual elimination of the claims handling process, presenting significant cost savings to the insurer. The predetermined trigger and pay-out mechanism create a situation where it is crystal clear whether a company will receive payment and exactly how much is owed.
The role of brokers
While the claims handling process becomes more streamlined after the policy is secured, companies considering parametric insurance policies will likely need assistance in the early planning stages of acquiring a policy. These companies will need to ensure that the triggering event and pay-out mechanisms are clearly defined and articulated in the policy. Without firm language on what constitutes a triggering event and how much will be paid exactly, companies risk leaving coverage gaps in their policy that could leave them on the hook for devastating losses.
Insurance brokers play a particularly important role in establishing and enforcing a robust process when it comes to purchasing a policy. This process goes far beyond that of traditional products, as parametric insurance is often a new product for purchasing companies. Insurance brokers that can truly understand the details of the product and its pros and cons for the policyholder can act as an adviser to clients. Additionally, brokers play an important role in identifying relevant data sources to set up an index appropriate to the exposures or coverage needs of the policyholder, especially for non-traditional risks. Aside from some additional work upfront, the obvious benefits of parametric insurance will likely lead to continued growing adoption. But before securing a parametric policy for themselves, businesses are wise to consult an insurance broker knowledgeable about the intricacies of these innovative products.
Insurance brokers experienced in parametric insurance policies will be able to parse through complex policy language to ensure an organization’s coverage needs are met. They can assess a company’s existing coverage and offer guidance in terms of where a parametric insurance policy could fill coverage gaps or provide an extra layer of coverage.
Duncan Ekasi Otiti ǀ CBOǀ Minet Lesotho
References:
https://www.insuranceage.co.uk/insight/7949721/experts-warn-clients-will-look-elsewhere-if-brokers-ignore-parametric-insurance / https://corporatesolutions.swissre.com/insights/knowledge/parametric-insurance-alternative-risk-solutions.html / https://www.hyperon.io/blog/how-parametric-insurance-is-reinventing-the-industry / https://minetgroup.blogspot.com/2022/01/a-challenging-time-for-intermediaries.html
https://www.marshmclennan.com/insights/publications/2018/dec/parametric-insurance-tool-to-increase-climate-resilience.html / / https://www.insurancejournal.com/news/international/2020/01/09/553850.htm / https://www.munichre.com/en/solutions/for-industry-clients/parametric-solutions.html#:~:text=The
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https://corporatesolutions.swissre.com/insights/knowledge/parametric-insurance-alternative-risk-solutions.html
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