Parametric Risk Transfer – When Does It Make Sense?

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Parametric insurance provides cover for predetermined catastrophic natural events such as an earthquake exceeding a certain magnitude, a hurricane producing a certain wind speed at a location, or a flood reaching into certain areas. The insured buys a predefined amount of protection that will pay out based on predefined terms regardless of the actual loss incurred. Parametric solutions work as a hedge and, when compared to traditional indemnity, there is often contention about their utility. However, there are a few circumstances in which the buyer of parametric products stands to obtain a great deal of value, according to Guillermo Franco, Global Head of Cat Risk Research, Guy Carpenter.

Parametric solutions were designed to eliminate the traditional claims adjustment process, which relies on an assessment of actual damages by a surveyor or claims specialist and which typically takes months or years to complete. In contrast, recoveries provided by the parametric mechanism can be accessed without dispute and within weeks of the event. This feature makes parametric solutions appealing when transparency and speed of payment are priorities.

Franco considers the events around the magnitude 8.2 earthquake that struck Mexico’s Pacific coast on September 8, 2017, as an example: “As part of the placement of the International Bank for Reconstruction and Development/FONDEN 2017 catastrophe bond, Guy Carpenter designed a parametric risk transfer solution for the government’s natural disaster fund. Under the agreement, USD 150 million was paid to the government within just 72 days of the event, enabling the government to offset the costs of initial response and recovery operations.”

“When evaluating the benefits of parametric insurance, the positive traits of speed and transparency need to be assessed against the cost of basis risk – the difference between actual losses and the recoveries received,” Franco adds. “When protecting specific physical assets this difference can have a dramatic impact. Picture the extreme case of a small event causing large damages without triggering any payment, leaving the policyholder with a shortfall. Covering this type of direct and well-defined physical damage might not be the best-use case of parametric.”

“Instead, consider the possibility of protecting more intangible losses such as those related to contingent business interruption, utility or transportation network failure, emergency response or supply chain,” Franco explains. “As those losses are much harder to evaluate than physical damages to a building, an insured may be satisfied with an approximate recovery that arrives fast, rather than waiting years for an adjustment outcome that, even after much effort, may remain questionable. Post-event situations are time-sensitive and a combination of adverse circumstances can trigger a secondary disaster. Businesses and governments should contemplate basis risk as a manageable cost they might be willing to accept in exchange for the speedy availability of funds.”

Guy Carpenter recognizes the significance of identifying the right situations for using a parametric solution: when loss compensation speed matters; when there is a need for protection from intangible losses; and when large events are certain to cause damage.

We understand that our clients’ needs are diverse and traditional insurance solutions may not always address them. Our proprietary parametric risk transfer solutions for earthquake risks, GC QuakeCube (SM), delivers:

  • Reduction of basis risk. We offer a global parametric earthquake product that features payment conditions according to a regular, high-resolution, three-dimensional grid. Optimizing the appropriate magnitude trigger in each grid cell, we can capture the risk of our client’s portfolio with greater fidelity.
  • Mitigation of model risk. We incorporate techniques to extend trigger conditions in areas where models may lack enough samples to appropriately represent local seismicity. This provides robust solutions less susceptible to shortcomings in the risk models or to potential errors in the reported parameters. 
  • Efficient design and placement. We offer prepackaged and off-the-shelf solutions, tailored to respond to industrywide losses, so the triggers can be effectively used as an industry loss index on a parametric basis. 
  • Deployment versatility. We can deploy our parametric solution as a cat bond or as a (re)insurance contract, depending on our clients’ objectives and requirements. 
  • Customization. We work with clients to determine the degree of customization necessary, ranging from minor tuning of an industrywide solution to a fully custom-built trigger that specifically captures our clients’ assets.