What is the most popular parametric solution?

Cat in a box explained

Cat in a Box, Cat in a Circle, Double Trigger, Single Trigger, Intensity. These are just a few of the many different names and structures of parametric insurance solutions that exist.

One of the most common parametric insurance structures used by our clients however, is the Cat in the Box, which will be the focus for this article. For those of you who are new to the concept this may all sound very complex (or just plain strange if you happened to type the search term "Cat in the Box" into google images), however as you'll see, in practice it is quite straightforward.

Firstly, a quick recap – what is parametric insurance and how does it work?

Simply, parametric insurance is based on a pre-agreed event occurring and a pre-agreed payout. It relies on a measurement of an event or index – such as temperature, wind speed, or precipitation – and unlike traditional indemnity insurance, it is independent from a client's underlying asset. As such it does not necessarily require physical damage to the underlying asset and allows for a quick formulaic payout once pre-defined parameters are met or exceeded.

Customizable to the individual client, parametric insurance can cover losses including (though not limited to) building damage, loss of profits or revenue, non-damage business interruption, increase costs such as expediting or labor costs, loss of land value, loss of attraction, advertising costs and more.

How a parametric solution is structured however, is central to how it works in the real world.

What can qualify as a parametric insurance "index"?

The selected event/index must be:  

  • Objective - independent, verifiable data
  • Reliable – from a data source that provides consistent and timely measurement
  • Available – access to historical statistical records to allow modelling
  • Correlated – with the economic loss sustained. Here, the Basis Risk represents the difference between pay-out and actual loss sustained

→  Read what is parametric insurance for more information.

What is a Cat in a Box parametric insurance solution and what are the benefits?

Today, Cat in the Box is still the most popular parametric insurance structure, where a payout occurs if a catastrophe such as an extreme weather event (the 'Cat') occurs in a given, pre-agreed area (the 'Box' – which in practice can take the form of a square, rectangle or circle). The 'Cat' must meet the minimum pre-agreed intensity threshold and go through the 'Box' to trigger the payout. You may also hear this type of parametric insurance solution referred to as a 'double trigger' as it requires the Catastrophe to occur in a predefined area (first trigger) and to be of a certain magnitude (second trigger).

The benefit of the Cat in a Box concept is that it is easy to understand and to implement. The notion of the "Box", whatever shape that may be, is an interesting feature as it means coverage is not limited to the insured's own locations but can also include other infrastructure critical for the client's supply chain. This provides clients with more flexibility as compared to traditional property damage business interruption policies.

What are the limitations of Cat in a Box parametric insurance solutions?

Since any index is only an imperfect proxy for the actual economic impact suffered by the insured, parametric insurance always has a residual basis risk (the difference between pay-out and actual loss sustained).

Recent advances in data analytics and data recording have allowed us to develop so called "2nd generation" parametric structures reducing this basis risk, such as intensity based covers. These covers are solely based on the actual intensity (shaking intensity or windspeed) that occurs at specific locations defined by the insured. This results in a closer correlation with the potential economic impact and thereby reduces the basis risk. Intensity based covers however require a certain level of granularity of data available to design the solution – as such it may be not be applicable for all perils or locations. QUAKE, STORM and FLOW are some examples of intensity based covers we've structured for clients.

So how does a Cat in a Box work?

Here's how a Cat in a Box works in practice. Take the example of a luxury hotel situated on an island. The hotel wants to protect itself against losses arising from a potential Category 3 or stronger cyclone within a 50km radius from its property. Here, our 'Box' takes the shape of a circle - Meet Cyclone Cat in a Circle.

When would Cyclone Cat in a Circle pay-out?

The solution would pay out when the Cyclone's track is

  • within the pre-defined area – in this example, a circle with a 50km radius AND
  • the cyclone's strength within the circle is at, or beyond the pre-defined threshold – in this example at or beyond a Cat 3 as reported by an independent party, for example, The Bureau of Meteorology.

What could the payout structure look like?

The payout pattern and limit is defined together with the client and their broker, taking into account historical losses and claims as well as risk engineering reports. The methodology to set a per event limit would be the same we would take to set any limit – parametric or not – and done by looking at the client's exposure to come up with a balance of cover and insurance spend.

Below is what a simple pay out structure could look like. The policy here is structured to pay out 25%, 50% or 100% of a predefined limit of USD 5M for a Category 3, 4 or 5 Cyclone respectively, happening in a 50 km radius around the point of interest – in this case, the insured's hotel. The settlement will be determined by the highest wind speed of the track points within the circle.

BoM Intensity Category

Wind Speed

% of Event Limit

Payout (USD)

1 Tropical Cyclone

63–88 km/h

0%

USD 0

2 Tropical Cyclone

89–117 km/h

0%

USD 0

3 Severe Tropical Cyclone

118–159 km/h

25%

USD 1.25

4 Severe Tropical Cyclone

160–199 km/h

50%

USD 2.5M

5 Severe Tropical Cyclone

> 200 km/h

100%

USD 5.0M

Tags

parametric innovativerisksolutions climatenaturalcatastrophes

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