Parametric Insurance: Closing The Protection Gap

The advantages of parametric insuranceFor example, there are policies that coverfood producers where demand for theirproduce is weather-sensitive, and providersof renewable energy whose output is relianton weather conditions. In September 2017,both AXA and Chubb Europe launchedparametric policies which automaticallypay insureds a fixed sum if their flightsare delayed by a certain amount of time.Other policies are available to thoseinvolved in logistics and hospitality,and parametric solutions can be usedto provide speedy interim payments forbusiness interruption.Parametric policies can also be offeredat a microinsurance level; sold directlyto the consumer via mobile technologies,or as an add-on to existing microfinanceservices. Pioneers in this field includeAXA and also Allianz, which in 2015provided microinsurance to 45 millionpeople in eleven countries in Asia, Africaand Latin America, including some ona parametric basis.PARAMETRIC INSURANCE OFFERSSPEED AND CERTAINTYSome key benefits of parametricinsurance are speed, certaintyof payout and the ability toplan ahead.These traits are particularly useful indeveloping countries where it is far moreeffective to respond before a loss eventhas turned into a humanitarian andeconomic crisis, with lives and livelihoodsat severe risk and a nation’s developmentpotentially put back years. Becauseparametric payments do not require lossadjusting on the ground, payments can bemade quickly to hard-to-reach insuredsin remote locations, often via onlinepayment platforms or through mobilephone networks.Parametrics are also extremely usefulwhere there are wide-ranging and hardto quantify losses, for example at thenational scale. Reflecting this, to date,national and regional governments withshared exposures have led the way inusing parametric insurance to distributefunds to member states in a risk pool.Someoftheearliestproponentsof parametric insurance were theCaribbean nations which came togetherafter the devastation wreaked byHurricane Ivan to create a regional riskpool against severe weather, now knownas the Caribbean Catastrophic RiskInsurance Facility (CCRIF).The benefits of parametric insurancehave been highlighted in CCRIF’s responseto hurricanes Irma and Maria wherethe facility was able to pay out overUSD 50 million to member countriessuch as Dominica, Antigua and Barbuda,and Turks and Caicos within 14 days. Incontrast, it is estimated that relief fundingfrom international development partnersnormally takes between four and 12months to mobilise.PREVENTION IS BETTERTHAN CUREThe economic benefits of early interventionare clear. The UK’s Department forInternational Development estimates thatit would have cost just USD 5 million tocontain the 2014 Ebola outbreak when itwas first detected in Guinea, potentiallystopping the outbreak becoming apandemic and saving thousands of lives.

11Donors ended up giving over USD 7 billionin aid for Ebola response and recovery.Since then, the World Bank has developedthe Pandemic Emergency Financing Facility,covering pandemic risk using an insuranceinstrument. Payments from the fund aremade when certain activation criteria aremet based on type of disease, outbreaksize, growth and speed. The World Bankestimates that if the fund had existed in2014 during the Ebola outbreak, the worldcould have mobilized USD 100 millionas early as four months after the outbreakwas confirmed and so accelerated theemergency response.In November 2017, the World Bankannounced it would be applying lessonslearned from the pandemic facility toaddress other humanitarian crises.Another fundamental benefitof parametric insurance forbuilding resilience is that apolicy can be triggered not bythe calamity itself (such as cropfailure or the resulting humanimpacts), but by its forebear(such as inadequate rainfall),which through funding earlyintervention can minimise widerhuman and financialimpacts and costs.For example, one parametric crop policyis triggered on satellite images of grazingland – where a lack of greenery or yellowland indicates the crop is failing. If fundscan be made available promptly to avulnerable region, resources can flow tofeed both people and livestock beforefamine strikes and migration follows.HOW DO PARAMETRICDERIVATIVES AND INSURANCEPRODUCTS DIFFER?Index-basedparametricinsuranceoperates in a similar way to certainwell-established types of product inthe derivatives market, such as weatherbased derivatives.In fact there is an overlap: what is inessence the same instrument can inmany cases be framed either as insurance(assuming the customer has an insurableinterest, and the provider is authorised asan insurer) or as a derivative. Professionalswith the expertise required to modelexposure and design a trigger can and domove between the two fields, and a numberof insurance groups have divisions thatdesign and issue derivative instruments.Insurance and derivatives can be used sideby side: this is the case with the World Bank’sPandemic Emergency Financing Facilityfor instance. Alternatively an insurermight issue a parametric insurance policyand hedge its exposure by purchasing aderivative, or pass the risk to the capitalmarkets through Insurance LinkedSecurities (ILS) products.

The advantages of parametric insuranceOVERCOMING BARRIERS TO ENTRYAs well as being well-suited to buildingresilience to natural disasters and weatherevents, parametric products can also helpovercome some of the barriers commercialinsurers can face when entering new anddeveloping markets.For example, governments in developingmarkets may have concerns aboutinternational insurers competing withlocal insurers for standard business. Thesebarriers tend to be less problematic wheninternational players can demonstratethey are offering something unavailable inlocal markets.Clyde & Co’s research, undertaken by itsinsurance teams globally, suggests thatin many parts of the world regulatorsand legislators are rapidly getting togrips with the opportunities presented byparametric insurance. Many regulatorsare now very amenable to and supportiveof their roll-out.On the supply side, parametric insurancemay provide a solution for issues ofscalability. It is commercially viable foran insurer to offer crop cover to largescale industrial farms in, say, the US,France or the UK, where premiums arelarge enough to cover underwriting andclaims management costs. In places suchas India, however, where the majorityof agriculture is through smallholdings,there are too many small farms andnot enough premium income to maketraditional models profitable. However,it is now increasingly feasible to coverthese farms through parametric policiespotentially sold direct to the farmer usingmicroinsurance principles.

13PARAMETRIC INSURANCEIN ACTIONMexico is a pioneer in the useof parametrics. In 1996, the Mexicangovernment created a national fund fornatural disasters — FONDEN — to whichit transfers budgetary funds for disasterrelief and reconstruction efforts. FONDENuses various financial instrumentsto support local states and entities inresponding to natural disasters, includingreserve funds and risk transfer solutions.Africa RiskView, a bespoke technicalengine used by ARC interprets differenttypes of weather data, including rainfallestimates and information about crops,such as soil and cropping calendars. Thisdata is then converted into meaningfulindicators for agricultural production andapplied to vulnerable populations thatdepend on rainfall for crops and rangelandfor their livelihoods. Africa RiskView thenuses this information to estimate howmany people may be affected by droughtor deficit rainfall in a given season.In 2006, FONDEN issued a USD 160 millioncatastrophe bond (called “CatMex”) totransfer Mexico’s earthquake risk to theinternational capital markets. It wasthe first parametric cat bond issued by asovereign.At the end of 2015, ARC announced a planto double its insurance offering througha replica coverage initiative which allowsinternational organisations to take out ARCpolicies that match those already provideddirectly to African governments, expandingparticipating countries’ coverage.African Risk Capacity (ARC) was launchedby the African Union in 2014. Designed toprovide an immediate financial payout tonation state members if there is a drought,the pool started with four countries aspolicyholders. In October 2017 Sudanjoined the ARC bringing the total numberof member countries to 22.More recently, in 2017, the World Bankdeveloped the Pacific Catastrophic RiskFacility (PCRAFI), a risk insurance poolfor five small Pacific islands. The projectbuilds on shared experiences from thesimilar catastrophe risk pools in Africa andthe Caribbean.

1996-2004The growth of parametric insurance199620012003Mexican government createsFONDEN, a national disasteremergency fund, using a variety ofinstruments.Swiss Re issues its firstparametrically triggered productscovering windstorms in Franceand hurricanes in Florida andPuerto Rico, plus long series ofparametrically triggered cat bondissues between 2001 and 2008.Swiss Re issues a series of bondswith parametric triggers for avariety of regions. The marketgrows dramatically.Munich Re issues its firstparametrically triggered cat bond.PRIME Capital CalQuake & EuroWind securitises its exposure toearthquakes in California andwindstorms in Europe.2004200520072012Munich Re places Euro 110 millionwith Aiolos to provide protectionagainst severe Western Europeanwindstorms.Caribbean Catastrophe RiskInsurance Facility (CCRIF) launchedas multi-country risk pool.Insurance leaders and the UNEnvironment Programme FinanceInitiative launches the UNEPFI Principles for SustainableInsurance. This frameworkaddresses environmental, social andgovernance risks and opportunities.Signatories include: Allianz, Aviva,AXA, Delta Lloyd, Generali, Mapfre,Munich Re, QBE, Samsung Fireand Marine, Santam, SCOR, TokioMarine & Nichido Fire Insurance,among others.1997Parametric Re providesUSD 100 million of cover for Tokyoearthquakes over 7.1. Payout linkedlevel reached above the M7.1trigger point for defined areasaround Tokyo.1998Other (mainly Japan-focused) bondsstart to use parametric triggers.Parametric triggers make up 44% ofall cat bond issuance in the market.2005-2013Mitsui Wind and Fire developsevent-linked swap based on7.1 magnitude earthquakeparametric trigger.The Hyogo Framework for Action2005-2015 launched the first globalplan to reduce disaster losses.2006FONDEN issues USD 160 million‘CatMex’ cat bond, the firstparametric cat bond issued by asovereign.DREWCAT issued by DominionResources a US energy and gascompany, protects against Gulfof Mexico hurricane risks for itsplatforms and installations.Midori Ltd bond issued withparametric trigger to coverearthquake risk for East JapanRailway Company.Medquake Ltd, bond withparametric trigger to cover severeearthquake risk in Turkey, Greece,Israel, Portugal and Cyprus.2009Second bond issue by FONDENwith parametric triggers.2013Turkish Catastrophe InsurancePool (TCIP) issues Bosphorus Re,parametric instrument to protectagainst regional earthquakes.Metropolitcan Transport Authorityof New York issues MetroCat Rebond covering storm surges on aparametric basis.

2014-201715201420162017African Union launchesAfrican Risk Capacity (ARC) topayout in the event of a droughtacross four countries (later joinedby Sudan in 2017).World Bank, the UN and insurancerepresentatives form the InsuranceDevelopment Forum (IDF).UK announces London Centre forGlobal Disaster Protection.2015World Bank launches thePandemic Emergency Fund,supported by Swiss Re.G7 launches InsuResilienceinitiative to deliver climate riskinsurance to 400 million of theworld’s poorest by 2020.Kenya launches innovative KenyaLivestock Insurance Program withparametric triggers.Allianz provides parametricmicroinsurance to 45 million peopleacross Asia, Africa and LatAm.Market Re, developed by Allianz,offers the first parametricinstrument offsetting the risks ofEuropean warm winters.The Sendai Framework for DisasterRisk Reduction 2015-2030 adoptedby UN Member States at the ThirdUN World Conference on DisasterRisk Reduction.September 2015 Mark Carney,Governor of the Bank of Englandand Chairman of the FinancialStability Board (FSB) delivers speechat Lloyd’s of London - “Breaking theTragedy of the Horizon – climatechange and financial stability”.Swiss Re launches first parametricinsurance programme againstnatural disaster risks for farmers inChina. Covers Heilongjiang provinceagainst flood, excessive rain,drought and low temperatures.AXA and Chubb Europe both launchparametric flight delay products.World Bank develops PacificCatastrophic Risk Facility (PCRAFI),covering five small Pacific islands.Atemis BM deal directory setsparametric triggered instrumentsat 5% of the total market.Metropolitan Transport Authorityof New York issues MetroCat Rebond covering storm surges andearthquakes on a parametric basis.UK’s Financial Conduct Authoritybrings parametrics into its testing‘sandbox’ and puts Floodflash, aneven-based flood insurance, intodevelopment.AXA Global Parametrics launchedto accelerate the development ofparametric products.UK government backs ‘GlobalParametrics’, a for profitcoalition aiming to provideinsurance instruments fordeveloping countries.Philippines establishesfirst-of-its-kind subnationalcatastrophic risk insurance programto provide 25 provinces with morethan USD 100 million coverageagainst major typhoons.IAIS (a global association ofnational insurance regulators)launches consultationon parametric insurance.

17LegalconsiderationsIf parametric risk transfersolutions are to move fromniche to mainstream statusas part of (re)insurers’offering in territories aroundthe world, regulators willneed to be on side.Under English law, insurance is acontract whereby for considerationone party promises to pay another if aspecified event occurs that is adverseto the interests of the insured. Thereis nothing within this traditionaldefinition to preclude a contract basedon a parametric trigger – the agreedparameters would simply be the arbiterof the “specified event”.Even though parametric insurancehas an established track record inmany countries, some regulatory andlegal uncertainty remains. Parametricinsurance products are novel and maynot be addressed by statute. Regulatoryframeworks that might exist in thisarea are usually not firmly codified andremain largely untested.Parametric insurance products maycause legal or regulatory uncertainty injurisdictions where:In common law jurisdictions, caselaw has yet to be established thatwould inform understanding of howthese types of policies will operate, beclassified for regulatory purposes andbe legally enforced.1.the insured must have an‘insurable interest’ at the time thepolicy is underwritten and/or atthe time the loss occurs.2.the size of the insurance pay-outmust correspond to the actualloss suffered by the insured. This‘indemnity principle’ can meanthat in certain jurisdictions, aninsurer may only restore insuredsto their pre-loss financial position,such that losses must be valuedor assessed before claims canbe paid.

Legal considerationsRECONCILING INSURABLEINTEREST WITH PAYMENTSTO INTERESTED THIRD PARTIESParametric insurance policies are oftenpurchased by sovereigns or sub-sovereignsand are becoming increasingly popularwith disaster relief and humanitarianorganisations.Under English law it seems readily arguablethat local, regional or even nationalgovernments have a direct insurableinterest in the effects of a natural disasteron their populations, since withoutinsurance backing they would have to fundthe full cost of the disaster recovery fromstate funds and could be expected to sufferlosses in tax revenue, for example.A non-governmental organisation (NGO)might have plans in place to intervenein a crisis (for example if crops wereto fail) even though it is not theNGO itself that is suffering the lossdirectly. Here the “insurable interest”may be slightly more tenuous, althoughon balance such a purchaser would likelybe able to show a legitimate interest inthe cover, rather than it representing amere speculation. Some jurisdictionsmay take a wide view and find aninsurable interest of a government inits territory and population or of an NGOin the people and places within its scopeof operations.There are other interesting potentialwork-arounds.In China, parametric insuranceproducts providing protectionagainst drought have beenarranged collectively at aregional government level,and reinsured byinternational players.Protection is then sold at a subsidisedpremium to individual farmers, whoeffectively become the policyholders andreceive payouts directly.The farmers themselves clearly havean insurable interest although it is thegovernment purchaser who has arrangedand subsidised the insurance as a meansof building local resilience within itspopulace.

19DEALING WITH VALUATION ISSUESUNDER THE INDEMNITY PRINCIPLEEnglish law has long recognised the conceptof valued policies whereby the insureragrees to pay a fixed sum once the lossis established, without a need for furtheradjustment or valuation at the time ofthe loss. However, the indemnity principlecan potentially create regulatory and legalchallenges in jurisdictions where codifiedinsurance law does not traditionally permit‘contingent contracts’, requiring insteadthat any losses are subject to valuation.In India there has been relativelywidespreadtake-upofparametricproducts particularly covering agriculturalrisks such as crop failure due to droughtor flood. For example, a number of thelarger multinational insurers includingAIG, Sompo Canopius and Tokio Marine –in conjunction with their Indian partners– have come together under the umbrellaof the Agriculture Insurance Company ofIndia Limited to offer parametric solutionswhich are generally purchased by farmersas a requirement of their lenders. However,because of Indian regulation and lawaround contingent contracts, the insuredneeds to prove to the insurer what the losshas been. This can, at times, slow down thepayment process and thereby somewhatdampens one of the key benefits ofparametric cover.The element of indemnity may alsohave an impact on how a product isclassified, regulated and taxed. TheUK Law Commissions note that themain difference between parametricinsurance and derivatives seems to be thatparametric insurance contracts usuallyrequire at least some nominal elementof loss before the policy will pay out andthat often insurers will require the insuredto provide a sworn proof of at least

close the protection gap (the amount of economic loss that isn't insured), which is significant in the developed world and huge in the developing world. Not only does parametric insurance potentially make insurance cover viable for millions of people, it reasserts the insurance sector's role as central to building resilience around the world.