June 8, 2022
Serena Sowers and Aaron Michel, Vice President, Senior Product Manager, Swiss Re
When discussing parametric insurance and its value to public entities, the conversation often involves innovative features of parametric products – speed, flexibility, and transparency. However, what makes parametric insurance valuable is as much the insurance aspect as its parametric qualities. With increased granularity and ubiquity of data coupled with advancements in technology, parametric insurance can reshape how the public sector accesses insurance.
To understand why parametric insurance is valuable to public entities, it is important to reflect on the motivation of public entities to purchase insurance and the gaps in the traditional programs they intend to fill. This big picture view highlights the efficacy of insurance to address the widening protection gap (See: Closing the protection gap | Swiss Re), especially when it comes to losses driven by climate change. Parametric products leverage data and technology to reshape the value of insurance and provide a mechanism to meet the growing needs of governments and communities.
Why do governments need insurance?
When dealing with catastrophic events, public entities experience financial challenges where risk transfer can play a critical role. Here are five (of many) key concerns that public entities express after a catastrophic event:
- Care for vulnerable and uninsured populations
- Budget strain and volatility from unplanned expenses
- Dollar-match requirements to qualify for FEMA and other federal government funds
- Bond obligations to protect credit ratings and borrowing power
- Recovery of local businesses and jobs
Underlying these critical priorities is the need for immediate liquidity and flexibility in how funds are used after a disaster because the public services that support sustainable recovery from catastrophes are vast and typically underbudgeted.
Insurance plays a critical role as a pre-disaster financing tool to address these post-disaster needs. Unlike post-disaster financing, insurance payments do not have to be paid back and are guaranteed to support the recovery process. This type of pre-disaster financing can reduce the need for taxes to pay for disasters.
What is parametric insurance?
In contrast to traditional insurance that pays claims based on incurred physical damage as assessed through a claims-adjustment process, parametric insurance responds when the characteristics of modeled or observed events are met or exceeded (e.g., size of hail, magnitude of earthquake, experienced windspeed, etc.). These measures of event severity are known immediately following an event, which allows parametric insurance payments to be assessed and issued quickly. With the proliferation in technology, new parametric products are increasingly available for various perils. Parametric insurance pushes the boundaries of traditional insurance by using data to offer alternative means to underwrite difficult-to-insure losses – unanticipated expenses, lost wages, revenue shortfall – and to offer alternative settlement processes (e.g., real time payments, advanced payments).
What specific value does parametric insurance offer?
The benefits of this type of insurance solution include:
- Rapid payments: Parametric insurance uses event parameters to issue payments quickly, permitting time for the insured to provide proof of loss as the disaster evolves. This allows the insured to focus critical resources on disaster recovery and not on the loss adjustment process.
- Flexibility of use: Particularly with public entities that have the responsibility to rebuild a community after a disaster, actual post-event expenses are significant and rarely anticipated or budgeted. Parametric insurance can provide the insured the flexibility to use funds as needed.
- Expansive coverage: Parametric insurance enables regions that have limited historical data or insurance penetration to access (re)insurance capital. This type of insurance can protect non-traditional assets that are invaluable and difficult to underwrite, such as natural assets.
What makes parametric insurance powerful?
The characteristics of parametric insurance – flexibility, rapid payments, broad coverage – are well suited to solve the problems faced by governments. These innovations enable the insurance industry to provide affordable solutions that address costs incurred by governments and communities. With advances in data and technology capabilities, increasingly large segments of society can be covered by parametric solutions. Parametric insurance enables resilient communities via:
- Inclusivity in insurance: Parametric insurance was developed for regions where insurance was previously not available due to lack of accurate data. Communities that previously could not purchase insurance due to inaccurate valuation of buildings, physical inaccessibility for claims adjusters, and limited asset volumes can now use event-based triggers to access risk transfer. Application of parametric concepts can help bridge the insurance gap in underserved communities.
- Accessibility and equity: Historically, insurance has been calculated based on the value of an asset, which is typically a physical property. With parametric insurance, there is the ability to protect value beyond a physical asset and populations with limited assets. This can be critical in helping understand the cost of shocks and stressors to low-income populations that suffer disproportionately after disasters.
- Mitigation with quick payments: Parametric insurance can reduce the long-term cost accumulation due to delayed repair. With modernization in payments, disaster relief that has taken months can now be offered quickly. This reduces costs, expedites recovery, and reduces disaster suffering.
What are examples of parametric insurance in action?
Parametric insurance can be used in many ways. Below are two specific examples of how this type of insurance solution has been deployed.
Pacific Alliance earthquake catastrophe bond in Latin America: Covering Chile, Colombia, Peru, and Mexico, the World Bank issued the largest ever sovereign bond for earthquakes, providing USD 1.36B in protection. The Pacific Alliance was regarded as an unprecedented effort to improve the risk management and resilience of Latin America to earthquakes. Investors agreed with both the message and economics, leading to an oversubscription with nearly USD 2.5B in orders. The parametric instrument was tested on May 26, 2019, when an M8.0 earthquake in Peru triggered a 30% payout (USD $60M) to the Government of Peru. The bond performed as intended, providing rapid liquidity to the Republic of Peru’s disaster fund.
State of Utah Parametric: Utah’s main objective was to supplement their traditional earthquake insurance and cover deductible expenses through the solution’s quick payment and flexibility. On March 18, 2020, the Salt Lake City area was hit with a 5.7 magnitude earthquake, the state’s strongest earthquake in nearly 30 years. The parametric product responded by delivering a partial payout of the limit within 30 days of the event.
Looking forward…
As we think about the value of insurance in helping build resilience, parametric insurance has demonstrated how the use of data and technology can reshape the capabilities of the insurance sector to better meet gaps and address evolving needs. Parametric instruments provide a solution that expands the traditional insurance market to tackle larger societal problems, such as natural disasters due to climate change.
Parametric options represent a segment of the insurance industry that embraces innovation. With that in mind, we think ahead to the next advancements that parametrics can facilitate:
- Can AI and machine learning help anticipate damage and the need for evacuation, mitigation, and advance payments?
- Can we re-shape disaster relief using data to prioritize payments based on need?
- Can we leverage payments technology and claims expertise to reach hard-hit populations in a more efficient manner?
These concepts are both enabled and catalyzed by parametric insurance, which allows the insurance industry to be more agile and responsive to community needs. As insurance markets continue to embrace and expand parametric offerings, governments and communities will be primary beneficiaries as they bolster their ability to respond to and recovery from catastrophic events.