Nir Kossovsky, chief executive officer, Steel City Re
17 October 2022ArticleAnalysis

Parametric insurance is not a swap; tax issues are clear

A panel discussion at the Vermont Captive Insurance Association (VCIA) annual conference this year prompted some confusion about the tax treatment of parametric insurance products. This was an unnecessary distraction. Parametric insurance products have a long history and the rules related to tax treatment are very clear.

A parametric insurance policy—one that is triggered and insures to model—that meets the Internal Revenue Service (IRS) test for insurance is insurance for tax purposes. Parametric insurance policies that have been in use for years have been underwritten by well-known insurers such as Swiss Re for weather loss, Munich Re for pandemic loss, and Tokio Marine Kiln for reputation loss.

Crop loss may have the greatest industry support from companies such as Sompo International, Cannasure, Munich Re, Descartes, AXA XL, and Allianz, to name a few. The most trivial example, mentioned in the session, is automobile insurance that insures total loss with parametric technology using a model provided typically by Kelley Blue Book, the vehicle valuation company ( www.kbb.com).

Parametric triggers for insurance can be anything quantifiable. In the case of my firm, Steel City Re, we use parametric measures of reputational value in our Tokio Marine Kiln policies. Parametric policies provide for ease of underwriting, facilitate claims adjustment, and enable coverage to insure complex risks including reputation and environmental, social, and corporate governance (ESG) factors-linked reputation loss.

Are swaps ‘insurance’?

At the VCIA panel, there was some comparison between parametric insurance and financial instruments known as swaps, which also use parametric measures to determine when a party receives payment. Swaps are sometimes thought of in a generic sense as “insurance” because they are usually used as a hedge against circumstances that would cause other investments to lose value.

However, there are several features that differentiate parametric insurance from parametric swaps, that are meaningful to the IRS and other taxing jurisdictions:

  • Insurance requires an insurable interest and a claim to be connected to a loss that has been incurred.
  • Insurance requires there to be a probability of loss.
  • An insurance policy cannot pay more than the total of the insured loss.

None of those is a features of swaps. Swaps are typically backed by the capital markets, rather than insurers, and in their most basic form, do not meet the IRS tests for insurance. Swaps are independent instruments that, while they may have parametric triggers, merely offer a counterweight to other investments.

Jonathan Spencer, a Vermont regulator, said in the VCIA session that parametric triggers were written intentionally vaguely into Vermont law as a way of deferring to the IRS on tax treatments.

Other captive jurisdictions are aligned. Responding to a written query, Mellisa Burgess of the Bermuda Monetary Authority wrote: “There is nothing in our legislation that prohibits a captive from using parametric technology provided there are adequate controls in place to effectively manage and mitigate the risks.”

Fenhua Liu of the Connecticut Insurance Department wrote: “The department doesn’t anticipate any issue for prospective captives to be domiciled in Connecticut to utilise Steel City Re’s behavioural economic underwriting; and parametric policy and pricing services to insure reputation and ESG-related risk.”

Apprised of Steel City Re’s parametric policy for reputation risk, Utah’s David Snowball wrote: “Utah does allow reputation risk as a line of coverage for captives if written appropriately,” and being similarly apprised, New Jersey’s Thomas Herriger wrote: “The Division of Insurance approves such utilisation (of Steel City Re’s parametric solution) as evidence of proper risk transfer.”

It’s important to provide clarity to captive managers on this question because, for a variety of reasons, well underwritten parametric reputation and ESG insurance can be an extremely valuable product for captives to consider. Our research shows that companies that handle these issues well, that have strong operational and governance processes in place, and that have outside validation—such as insurance—backing them up, generate a significant “reputation premium”.

Not only does it appear transparently in the profitability of a captive, but uniquely among the myriad risks to be managed, the premium for well-managed ESG-linked reputation risk appears at the enterprise level in the form of enhanced stock price performance relative to their peers. That’s a tremendous added value that captive managers can provide.

Nir Kossovsky is the chief executive of Steel City Re. He can be contacted at: nkossovsky@steelcityre.com