In our last article "What is parametric insurance?" we established the basics of what a parametric insurance solution is – its key attributes, how it works and what makes it different from a traditional insurance solution.
However, we often hear a number of misconceptions about parametric or index based insurance solutions. In this article, we wanted to set the facts straight about the top 10 myths that we often come across when presenting parametric insurance solutions to clients.
Myth 1: Parametric solutions are always more expensive than traditional indemnity insurance
We hear this one a lot, and cost or "rate on limit" is often a concern that arises when parametric insurance is mentioned.
The truth is that parametric and conventional indemnity insurance cannot be compared like for like. They do not cover the same things, with parametric insurance filling the protection gap left by indemnity insurance from deductibles, excluded perils, scarce capacity, or to address situations like contingent business interruption or wide area damage.
Parametric or index based insurance solutions are purely based on the probability of a pre-defined event (eg. a Cat 5 Tropical Cyclone or Earthquake of Magnitude 7) happening. Since they are detached from any underlying asset, the asset's vulnerability does not enter the equation. Simply put, if the likelihood of the Earthquake happening is 1 in 100 years – the rate on limit will be at least 1%, regardless of the underlying insurable interest.
So the art of structuring an adequate solution is to set the trigger and payout structure at the right levels to keep the price in check without compromising the cover needed.
Staggered pay-out structures or multiple triggers are mechanisms to tailor parametric insurances.
Important to keep in mind is that parametric insurance solutions are not designed to replace traditional insurance, but to complement it for pure financial losses or uninsurable perils.
Myth 2: Parametric insurance is complex and difficult to understand
In fact the opposite is true! Parametric or index based insurance solutions are quite simple and more transparent than traditional insurance: If a defined event occurs or the index threshold is met, the policy is triggered and a pre-agreed payout is made within days of the occurrence.
Some of the perceived complexity might come from the structuring process, which often involves a few iterations but is key in order to reduce basis risk and tailor the solutions to meet the specific needs of a client. With parametric insurance, there is no fine-print.
Since the asset vulnerability does not enter the equation, the underwriting and claims payment process are much simpler than for traditional insurance: no site surveys or risk mitigation assessments, no tedious loss adjustment processes.
If you haven't already, read our previous article, which explains the fundamental concepts of parametric insurance and gets down to the basics.
Myth 3: Parametric insurance replaces traditional insurance solutions
In fact parametric or index based insurance solutions are specifically designed to complement, not to replace, traditional insurance programs. We usually see them deployed to fill current protection gaps or exclusions of a traditional program.
Because of their fundamental nature, index based solutions are an ideal instrument to cover pure financial losses that impact businesses without causing physical damage to their assets eg. Loss of attraction due to a typhoon approaching, supply chain disruption due to floods at third party premises etc.
Myth 4: A Parametric solution is not an insurance contract and can create accounting complexities
Generally speaking parametric solutions can be executed as an insurance contract or as derivative, depending on the preference and needs of the client. It always depends on a country's regulatory and legal framework, but usually the main difference is that an insurance contract requires an "insurable interest" and a "proof of loss". If executed as an insurance contract, the policy follows the same accounting rules and principles as any other insurance contract.
In a simplistic way one could differentiate between:
- Pure parametric covers which provide a pay out of a specified amount upon occurrence of a certain event, regardless of any economic loss sustained by the client. They are generally executed as derivatives
- "Hybrid" covers where both a parametric (pre-defined event parameters) and an indemnity condition (proof of loss) must be fulfilled for the policy to trigger a payout. Such covers are structured as insurance contracts.
Myth 5: Parametric insurance is like gambling
This misconception is somewhat related to the above Myth #4. Fundamentally the difference between insurance and gambling is the existence of exposure and thus an insurable interest.
Whilst a parametric solution executed as derivative could technically result in a positive basis risk (ie. payout without an actual financial loss sustained), most risk transfer solutions in the corporate world are written as insurance contracts requiring a proof of loss.
In any case, we are looking at parametric solutions as risk transfer instruments and I doubt that any risk manager would have an interest to pay premium for a "corporate gamble".
Myth 6: Parametric solutions are only appropriate for large organisations
Index based insurance solutions exist in a wide range of sizes and guises. On one end of the spectrum are the highly customized and bespoke solutions that are structured for specific needs of a usually larger corporation, but on the other end are highly standardised solutions that are sold online with only a few mouse clicks.
In particular, more standardized solutions like "Cat-in-a-box" or Swiss Re's "Insur8" product are specifically geared for the SME markets and standardized to be an efficient instrument also for smaller limits.
Myth 7: Parametric products are limited to covering property exposures
Actually the opposite is true!
Parametric insurance solutions do not cover a specific physical asset or property but they are solely triggered by a pre-defined event occurring. As such they are most useful to protect against pure financial losses which are not caused by damage to a physical asset, or where the underlying asset is not within the insured's control.
Examples of parametric insurance solutions include train and or airplane delays, loss of attraction due to transboundary haze or inclement weather causing project delays.
Myth 8: You can use parametric solutions to cover all uninsurable risks
Parametric solutions can certainly push the envelope of insurability, but they are not the panacea for every risk. The fundamental requirement is always to have a trigger that is fortuitous, can be modelled and is correlated with the financial exposure of the insured.
As such they certainly can complement traditional insurance programs and fill some gaps left by conventional programs, but there will be residual risks that the insurance industry has no appetite for.
Eg. Pure business risks like performance related exposures or product development risk will remain difficult to transfer to an insurer and stay with the shareholders.
Myth 9: Parametric solutions only apply to Nat Cat events
Whilst Nat Cat events are a very common trigger for parametric insurance solutions there are dozens of other triggers and applications for index based covers.
Any index that has a fortuitous element or volatility can theoretically serve as trigger. Nat Cat events - and weather in general - are just very prominent triggers because they definitely fulfil the fortuity requirement and usually impact the financial performance of businesses.
Beside the more common weather triggers like temperature, irradiation, wind speed or precipitation, we have structured covers involving a range of other, non-weather related triggers like regulatory decisions, loss of attraction, pandemics or power plant outage risk.
Myth 10: Parametric insurance always has large basis risk
While basis risk gets usually associated with parametric insurance, basis risk exists within all insurance structures. In traditional indemnity insurance basis risk takes the form of deductibles, sub limits or policy exclusions, which can lead to a mismatch between the policyholder's coverage expectations and the actual indemnity payment made under the contract. With parametric solutions, basis risk arises from the correlation of the index with the risk. Simply put, it is the difference between an insured's loss and the parametric insurance recovery.
It is an inherent element of parametric or index based solutions, and whilst basis risk can be reduced or mitigated, it can never be completely eliminated.
The art of structuring insurance solutions lies in reducing this basis risk and make sure any formulaic payout corresponds a closely as possible to the loss sustained. This is usually achieved with refining the index and optimizing the pay-out structure.
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