Parametric for captives: a world of advantage

Meryl Bermond (pictured), captive insurer lead, Descartes Underwriting, highlights the benefits of parametric insurance products for captives.

Of all the challenges faced by captive insurers in their cooperation with the commercial insurance market, the greatest might be the cyclicality of risk-transfer pricing. Radical swings in the cost of a specific type of coverage, sometimes by hundreds of percent over just a year or two, can overwhelm a captive’s fundamental need to receive the correct risk-based premium every time.

Unfortunately, most insurance-market partners’ prices are based on factors such as loss experience and market competition, as well as underlying risk. This can leave captives scrambling to cover claims they insured too cheaply. When integrated into conventional insurance programmes, parametric insurance provides a solution.

Pure risk pricing

By removing uncertainty over the quantum of the indemnity and instead insuring only the likelihood of the occurrence of an event of a specific intensity, parametric structures deliver transparent and accurately priced coverage for specific, difficult perils such as hurricane and hail. 

Parametric insurance prices are calculated scientifically based on the risk, rather than competitively with a loading for recent loss experience. This risk-based pricing approach ensures captives receive the premium they need to cover losses. 

For example, a parametric policy might deliver $100 million of coverage in the wake of an earthquake which caused peak ground acceleration of 0.8g as measured an insured location, or $80 million in the case of a magnitude 0.6g event. The underwriter needs to consider only the likely occurrence of the loss event, not the level of damage, when setting the price. Loss assessment and coverage disputes are eliminated.

Triggers with a payout which increases with the intensity of the event help to ensure that the actual losses experienced match pre-agreed claim amounts as closely as possible. The value and vulnerability of insured structures are considered, but to help determine the limit required.

Natural perils

Natural perils present captives with the greatest property-loss potential overall, because unlike most others, they pose a serious accumulation risk. They are also among the most challenging to underwrite. Not only is the weather notoriously difficult to predict, but now it’s changing.

Many conventional all-risks policies cover nat cat alongside fire, theft and disaster losses, and perhaps even strikes and riots or other events, but all-risks insurers might be on very shaky ground when pricing the catastrophe exposures within these coverages. Sometimes no loading is made for so-called secondary perils such as flood and hail. Some risk carriers default to a sub-limit for events which pose accumulation risk. Capacity for others, such as Florida hurricane and California wildfire, might simply be unavailable at any price. 

These risks can be carved out completely, then covered at the correct risk-based price with properly underwritten parametric insurance. Advanced data analysis and modelling should ensure accurate pricing. When events occur – and they’re happening more often due to climate change – captives covered under parametric policies underwritten by reputable specialists will have received sufficient premium to cover natural perils risks. 

For example, property policies typically cover hail losses, but the hail risk they include is almost never assessed and priced. Instead, it is given away for free. When a captive receives a hail claim, future premiums must increase to make up the shortfall. 

Parametric hail protection is priced according to the peril alone. The underwriters model the likelihood of the event occurring, and its severity based both on hailstone size and storm intensity. They provide captives with this detailed pricing information, which ensures they receive premium adequate to cover increasingly likely losses due to hailstorm. 

Competent parametric insurers will back-test a captive’s loss portfolio to show how parametric coverage would have responded to the real events which led to claims. That knowledge, alongside the parametric insurer’s deep understanding of the likelihood of the occurrence of specific natural events, means they can then manage the captive’s risk under accurately priced policies issued either directly to the client as a fronting underwriter, or by reinsuring the captive’s primary policies, as is their preference.

Forward thinking

Historical loss records are valuable when determining the amount of coverage which an insured is likely to need for a specific peril. However – and this is important – the loss record does not impact upon the price of a unit of parametric coverage. This new, peril-focused type of insurance is loss-record-agnostic.

Maybe the peril is flood, and the captive belongs to a company which owns and operates hotels worldwide. The captive may have paid 25 flood claims in the past 10 years for 25 different flood events. A conventional insurer would be much more likely to charge that company a higher rate than one that had run clean or had only three or four claims over the same period. 

A parametric insurer would calculate the flood risk at each location, and price based on the risk. If the client’s risk management was poor, making loss more likely, they should buy more coverage, but this would not affect their price per unit of limit. Similarly, if our flood-prone hotel chain spends a lot on risk mitigation and management, they may wish to purchase coverage only for less likely flood events (which obviously would be less expensive per dollar of cover), since they are now able to endure minor floods without a loss. 

No damage? No problem

A parametric benefit of particular value for captive insurers is the ease with which the approach is able to cover business interruption losses. Under conventional insurances, BI coverage is triggered by the occurrence of a physical loss. However, as any business owner knows, millions can be lost without physical damage, perhaps due to a supply chain interruption. Conventional insurance, called contingent BI or non-damage BI, is available for such losses, but the market is small, coverage costly, and claims are typically protracted. 

Parametric is better. Say an earthquake in Taiwan shuts down a US manufacturer’s microprocessor supply. With the resulting global demand surge eliminating immediate supply alternatives, local manufacturing must halt. Parametric insurance can remove that risk and deliver a substantial payment within weeks of the earthquake, without quibbling over the actual value of the intangible loss.

In another example, a hurricane may leave a retail facility undamaged. However, floodwaters, blocked roads and evacuation orders may completely halt all trade. Even without physical damage to the shopping mall, a parametric policy would pay out when a wind field of a specified velocity passes within a stated proximity of the mall. The size of the claim due may increase with the windspeed, based on the policy structure. 

The captive market, traditionally the most experimental and innovative corner of the world of insurance, should look closely at parametric insurance to learn how it can enhance risk-transfer programmes and reduce unexpected financial loss. The parametric approach underpins business continuity and price stability over time. It is a boon for captives, since it eradicates almost all the features of conventional insurance which lead to inadequate risk pricing. 

Meryl Bermond is captive insurer lead at Descartes Underwriting. She can be contacted at: meryl.bermond@descartesunderwriting.com

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