A fact that has been hard to swallow and often debated is that insurance is not available to cover every loss. There are various reasons for this – perhaps the loss cannot be modeled with any degree of predictability to enable insurers to set an appropriate rate for coverage, or the loss is not accidental in nature and could have been prevented, or the loss would be so widespread and catastrophic that insurers could never take in enough premiums to cover all the policyholder losses, which of course can be said of pandemics. The current COVID-19 pandemic has hit businesses and the economy hard and so policyholders are looking to their insurers to recoup some of their financial loss, regardless if coverage actually exists on the policy for those losses. Because pandemic coverage is nonexistent on standard insurance policies, the question arises as to who should (and how to) cover the various costs arising from COVID-19 today, and any similar pandemic in the future. Therefore, the problem is being discussed and debated between insurers, governments and the capital markets.
This is where parametric insurance could come into the realm of future possibilities. Parametric insurance offers financial protection against losses that are often hard, or even impossible, to get insurance for, but in a nontraditional insurance structure. Traditional indemnity insurance, the kind we are all familiar with, pays out based on the cost of the loss incurred. Parametric insurance pays out when a predefined loss event occurs and the loss event exceeds a specific dollar or index amount that was preagreed to in the policy. Examples of perils covered and typical triggers include hurricane (wind speed), flood (height), earthquake (shake intensity), pandemic (number of infections) or cyber (reported data breach).
Take for example (quite simplified), flash flood insurance that is being offered in the U.K. on a parametric basis. Once a flood's water reaches a certain specified depth, the parametric policy pays out the amount specified in the policy, regardless if the insured actually suffered a loss from this flood. A parametric can be looked as an "objective" trigger. The trigger is set on the policy at the predetermined amount based on supporting data of prior floods and losses. Both the insured and insurer agree to this amount so it is a contractual agreement between the parties. The trigger that is set on the policy must correlate to the damage, so having supportive data is paramount. Advantages to an insured are that because the insurer knows how much the policy is going to pay out prior to the loss, claims are settled virtually immediately and the insured gets paid out quickly. If the insured has the coverage and the flood is at their premises, then the policy will pay out, regardless if there was actual damage, so the insured knows they will receive a payout once the water level reaches the established threshold. The insurer knows exactly how many policies will be affected by a given flood, eliminating uncertainty. Therefore, the policies are less expensive to the insured, and the insurer has greater predictability of losses and can set rates accordingly.
As with any catastrophic loss, policyholders have an immediate need for cash to survive. Having parametric insurance would ensure they get the agreed amount almost immediately, which could mean the difference between survival and nonsurvival, particularly for small to medium businesses.
So what if the insured had greater losses than the predetermined amount? Well, this is where parametric insurance cannot be looked at in the same way as traditional indemnity insurance. It is not an indemnity policy-it is a trigger based policy. The insured would bear his portion of the loss, but for many insureds, this concern is offset by the lower policy premium and the certainty of a specific dollar amount to be paid quickly.
So where does the capital come from in a parametric arrangement? Parametric structures are attractive to capital providers from outside of insurance (hedge funds, banks, pension funds and dedicated investment vehicles). When they are designed properly, parametric-based insurance products ensure that claims are paid fast, and without dispute. The event is precovered at a predetermined amount for a preset trigger event.
Today, the ILS market provides $100 billion of protection, with the majority of that capital coming from outside of insurance. Most ILS bonds still use traditional indemnity losses to set the payout, but parametric triggers have been used for 15 percent of these bonds. Investors like parametric structures because the investors know as much about the risk being covered as the original insured does, which is not the case in traditional indemnity insurance. Coverage for ILS bonds is usually in the hundreds of millions of dollars, with sophisticated payment structures.
Information sources on catastrophe bonds anticipate that the $500 million pandemic catastrophe bond issued by the WHO is considered to have a high probability of being triggered.
Parametric insurance is a way to bring innovation into insurance. Parametrics open up opportunities to those that can build, or tap into, a source of reliable data, preferably with years of historical records, that can be used to create indices that correlate with financial losses. These can be particularly valuable if the data source is exclusive.
MGAs and brokers that are technology-based with clients struggling to get the insurance they need are starting to turn to parametric insurance. The concept has also been used for a number of years in microinsurance.
This is just the beginning of what we will be hearing about in the way of parametric insurance, as catastrophes increase and insurers seek more innovative ways to provide affordable coverage with greater predictability.