Nat Cat Parametric Coverage: innovative risk financing in the face of climate change and unpredictability
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A version of the following interview originally appeared in the January 2020 edition of the Captive Insurance Company Reports. To obtain the original copy, visit CICR.
What are the fundamental drivers behind the rise of natural catastrophe (nat cat) parametric solutions? Why are corporate buyers seeking alternative risk transfer solutions?
Let's examine several drivers within the risk management and financing markets. One of them is a rapidly growing reality and the impact of global climate change. Changes in weather patterns, rising sea levels, and increased severity of weather-related events – all are changing and reshaping the planet’s climate (see our latest nat cat sigma for more on that). North America has experienced several large natural catastrophes in recent years, including hurricanes making landfall in the United States and in the Caribbean as well as earthquakes and wildfires in Southeastern California.
Secondly, there is a significant volatility in the insurance market, with increasing rates and reduced available capacities for risk transfer. The consumers – insurers through re-insurance, corporate buyers faced with increased deductibles and risk retentions, or self-insured municipalities looking to assemble risk protection for infrastructure – are all seeking compatible structures along with their traditional programs or creating new structures for assets vulnerable to natural catastrophes.
Finally, there is a growing desire to supplement gaps in traditional insurance contracts with subjects to payment delay, large percent deductibles, exclusions, and complex language to a new environment based on transparency, dependability, simplicity, and speed of payment. The goal is to stabilize a changing market with new approaches that will reduce volatility in an uncertain environment.
Why are corporate customers changing their approach toward risk structuring behind nat cat exposures?
Corporations are just one group of insurance buyers – risk managers who are interested in innovative solutions to augment their existing catastrophe risk programs and integrating alternative capital structures with traditional insurance and reinsurance. As the traditional markets reposition to address the changes in risks and exposures, those entities seeking risk protection must also evolve their programs.
Today, natural catastrophes occur with less reliable predictability. Hurricanes of higher intensities are more frequent. New exposures, such as wildfires, or secondary perils, such as convection storms, are happening with increased severity.
Corporate customers are also aware of operational interdependence with multiple suppliers and economies around the globe. A comprehensive analysis of nat cat exposures needs to be global in scope. Catastrophes rend to have significant financial impacts without necessarily damaging fixed assets directly. Companies are exposed to events that impact the supply chain and transportation infrastructure, such as highways, rail lines, river traffic, and ports, and area-wide devastation post-event. Traditional indemnity-based insurance products work well when the loss of income and expenses arise from physical damage. In the event of no physical damage, you need something more flexible.
What are some of the key corporate customer needs that should be addressed?
Managing the increased risk exposures associated with a changing climate is key. It's important to accurately identify assets at risk and properly value them. A risk manager must know the exposed aggregated values and ensure that they do not exceed the corporate risk appetite and tolerances.
It is imperative to educate the entire C-suite leadership team – CFO, COO, HR, etc. – on the issues and risks. A peer assessment of risks, financial exposures, and risk structures in place to protect those corporate assets is also important. A corporate customer needs to think beyond the balance sheet. They need to identify the risk and exposures associated with the supply chain, key customers, and human capital. This requires a much broader view with the ability to quantify and communicate the potential impacts most effectively. Given the potential impacts of a natural catastrophe, risk managers are there to help understand, analyze and educate on those implications.
Traditional insurance is indemnity-based. Coverage is provided for physical damage to assets. Any indemnification for damages is based upon contractual terms and conditions contained within the insurance policy. Deductibles, valuation clauses, exclusions, limits, and sub-limits are typically contained in an insurance policy/contract. In addition, business interruption and extra expense coverages are provided only as a direct consequence of physical damage to the insured property.
A parametric contract, in contrast, is index-based. Coverage is triggered and only paid when predefined and measurable event parameters – such as wind speed or earthquake intensity –are met or exceeded.
As a result, contractual payments are made quickly (often within 30 days or less.) In addition, coverage is very broad, including direct and indirect losses and all event-associated expenses. Parametric nat cat policies are free of dollar-based deductibles, exclusions, and complicated loss adjustments.
Parametric or indexed insurance products require a post-loss payment certification process, which is a simple one-page confirmation of the loss impact (that may potentially adjust the amount paid.) This feature avoids any windfall profit for the insured, maintaining a very basic tenant of insurance. Combined with the quick, formulaic parametric payout, this provides an expedited financial response at a time when the insured needs to get the enterprise back in business.
Looking ahead, what do you see for nat cat parametric coverage?
The trend of extending innovative risk transfer solutions to increase the larger societal resilience is likely to continue. For example, our STORM and QUAKE solutions are the second-generation parametric products. The triggers and third-party independent settlement parameters are wind speed exceedance (miles per hour, as reported by RMS Hwind) and shake intensity (pseudo-spectral acceleration 0.3s, as reported by the US Geological Survey ) at the insured’s locations. Basic risk of Cat in the Circle or Cat in the Box is greatly reduced, which results in an improved solution for corporate insureds.
Most nat cat parametric products are geared toward supplementing, not replacing, traditional insurance. Indemnity insurance policies are becoming far more restrictive with convective storm/hail cover and flood covers related to storm surge and river height. Parametric covers are gaining traction as nat cat events increase in frequency and severity and as the insurance market hardens.
Large corporations are now creatively using parametric covers to increase the resilience of their customers and employees. Several corporations are cross-selling parametric products to small and medium-sized enterprise customers to grow their top and bottom lines. Some companies are offering parametric earthquake insurance to their employees to improve the resilience of the employees and, in turn, their own business.