Article first published in Insurance Day

Risk-pooling facilities and products using parametric triggers to determine payout present a viable way to bring insurance to vulnerable people

Where there is insufficient insurance penetration in a country or region when natural catastrophes occur governments and aid organisations must step in to fill the gap, mobilising disaster response and rebuilding infrastructure often at high cost.

This "protection gap" is widest in developing countries where unsafe building practices and inadequate disaster preparedness mean resilience is low and catastrophic events can carry a much higher cost in lives and livelihoods.

But the issue is not confined to developing countries, as exemplified most recently by the earthquake in Umbria, Italy, where the lack of domestic insurance coverage for earthquakes was one of the factors leading to the large shortfall between insurance recoveries and the expected short- and medium-term economic impact of the quake.

Wide protection gaps globally, coupled with a growing awareness of the need to build resilience at national, municipal and community levels, represents both a challenge and an opportunity for the re/insurance market.

Some national governments, recognising their populations are particularly exposed to certain weather-related risks, have collaborated to pool risk in regional insurance facilities that respond to severe weather events. Examples of regional risk pools include African Risk Capacity and the Caribbean Catastrophe Risk Insurance Facility.

Parametric triggers

Although based in very different regions and responding to different types of peril (for example, catastrophic drought in Africa; earthquake, tropical cyclone and excess rainfall in the Caribbean), these risk pools have in common the use of parametric triggers for release of funds. Parametrics are commonly used in the catastrophe bond market as a means of triggering payment to the bond issuer (usually an insurance or reinsurance company) when disaster or weather conditions reach a certain level of severity.

Essentially, parametric insurance products provide a near-automatic payout in response to certain defined threshold parameters being met. For example, a parametric product designed to respond to an earthquake could be triggered to pay if a quake of certain magnitude is measured at a certain location. A parametric product for hurricane damage could be triggered if winds reach a certain velocity in a defined zone.

Parameters are set at the time of entering into the policy by agreement between the insurer and its policyholder (or between a reinsurance company and cat bond investors). Parameters for the trigger are based on quantitative data, ordinarily provided or verified by a recognised independent third party or bespoke data analysis system. For example, African Risk Capacity uses Africa RiskView, a software platform developed by the UN World Food Programme to interpret satellite-based rainfall data, model the risk of drought and estimate response costs across the continent.

One of the key benefits of parametric insurance products is speed of payment. This is particularly important where the insurance payment will fund costs of intervention after a catastrophe. Traditional indemnity insurance requires an assessment of the value of the insured's loss and the claims handing and loss adjusting process can slow down the release of emergency funding vital to businesses, aid organisations or governments in the aftermath of a large-scale natural disaster. Traditional indemnity insurance also customarily has various conditions, exclusions and limitations which may introduce uncertainty and delay.

Unlike indemnity insurance, parametric products can also be designed to respond to harbingers of more destructive losses and provide upfront cashflow aimed at preventing misfortune from becoming catastrophe. For example, parametric insurance can provide an ex-ante payment where a crop looks likely to fail (for example, by reference to average temperatures or rainfall in a certain area) so relief structures are put in place before actual crop failure.

What a parametric model gains in speed and certainty of payout it may lose in accuracy, since actual damage on the ground may be more or less than the pre-determined payment. This basis risk means parametric products to date have tended to be more attractive to governments or reinsurers than to individual insureds, who may prefer to know that their exact losses will be indemnified. Advances in parametric modelling are, however, reducing this basis risk to a more acceptable level, in turn expanding the market for this type of insurance.

Proper design

Modelling must ensure triggers for insurance payouts are properly designed so payments are not released when they are not needed or, conversely, the insurance fails to respond when it should. It is paramount the correct data sets for triggers are carefully identified at the outset and accurately measured and reported during the policy period. The arbiter of whether the event parameter has occurred should be an independent and reputable third party, such as a weather or earthquake monitoring body.

The modelling and design work required by parametrics can be expensive, but with new thinking on modelling and technological advances making new data sets available, highly accurate parametric products may become less costly and more widely available.

Parametric products using satellite technology are increasingly being used by national and regional governments as a cost-effective hedge against weather-related risks. For example, last month Swiss Re entered into a reinsurance programme with the government of Heilongjiang province, China and the Sunlight Agriculture Mutual Insurance Company of China, which incorporates satellite-based parametrics to fund assistance for farmers in the event of crop failure as a result of drought, excessive rainfall, low temperature or flooding. There may soon be many such public-private partnerships using parametrics to manage natural catastrophe risks and fund a (sub)sovereign's efforts to protect its most vulnerable citizens from climate shocks.

This is a good example of the types of risk parametric products seem uniquely adapted to cover: natural perils that could expose large numbers of vulnerable people and which are difficult to cover on a conventional indemnity basis on the open market. Other examples include rice production in south-east Asia and the World Bank/World Health Organization's new parametric-based Pandemic Emergency Facility, designed to respond to outbreaks of infectious diseases in the poorest countries – for example, in any future outbreak of Ebola in West Africa – launched earlier this year.

With innovative design for parametric insurance products, rapid scientific advancements in measuring data and modelling risks and ground-breaking public-private partnerships at a national, regional or international level, insurers and reinsurers are reaching new markets and finding ways to close the protection gap.