January 16, 2017

Parametric insurance can boost protection for developing nations

Around the world, natural catastrophe losses are often exacerbated by a lack of adequate insurance, a problem that is especially acute in developing countries. Confronted with a growing gap between insured and uninsured losses, what can the global insurance industry do to mitigate the effects of disasters in the developing world?

One innovative solution is parametric insurance. Unlike traditional insurance, which provides indemnification for specific losses arising from a covered peril, parametric insurance pays out a predetermined amount triggered by one or more parameters. For example, parameters can include wind speeds for hurricanes, magnitudes at specific locations for earthquakes, or rainfall in a defined period. Parametric alternatives to pure indemnity include parametric indexes and loss modeling. A downside to a strictly parametric approach is high basis risk. In a catastrophe loss context, this is the risk that a payout may be higher or lower than the actual loss. Catastrophe events have been known to cause disproportionately large or small losses, depending on where they occur. Indexes and modeled-loss approaches reduce basis risk.

Basis risk aside, there are several advantages to parametric approaches, which are particularly helpful to nations with relatively limited resources. Not least is that claim assessment and documentation are not required. Another is reduced uncertainty; parametric insurance does not rely on exclusions, conditions and limitations that can give rise to coverage disputes. Yet another advantage is the speed of claim payment. Claims under conventional policies take time to document and assess - especially following a natural disaster, when site access is typically challenging for policyholders and adjusters. Under a parametric insurance product, if the parameters are met, the next step is payment.

A final advantage of parametric insurance is that the concept does not need proving; it is already in use by insurers and reinsurers. Over the past 20 years or so, the insurance industry has expanded its use of insurance-linked securities such as catastrophe bonds and industry loss warranties. These instruments rely on parametric triggers and have earned a place alongside traditional insurance and reinsurance programs. A significant opportunity exists to expand this protection throughout the developing world.

A sad reality is that the developing nations that are often the most exposed to natural catastrophes are also the least equipped to shoulder the losses. These nations stand to benefit greatly from parametric insurance as do donors, governments and NGOs who support those countries with aid. The CCRIF SPC, a catastrophe insurance facility for Caribbean nations, has paid out tens of millions of dollars in claims following Hurricane Matthew, which caused devastation as the strongest hurricane in the Atlantic basin since 2007.

According to Swiss Re data, 2016 saw disasters claim about 10,000 lives and generate total losses of $158 billion. Of that amount, only $49 billion or 31%, was insured. And the uninsured total increased 68% from the prior year. The gap between insured and uninsured loss is indeed a significant burden.

CCRIF, which previously used a parametric index, has shifted to a modeled-loss framework to reduce basis risk by modeling each loss as it occurs. If the modeled loss exceeds the minimum agreed in the policy, then coverage is triggered. The ability to reduce basis risk while preserving the efficient disbursement of funds after a disaster is a powerful combination that could promote parametric insurance more widely among governments, non-governmental organizations and commercial enterprises and the communities they serve. The challenge for the insurance industry is to spread awareness and adoption of this valuable form of protection.