Captives offer businesses a route into the world of parametric insurance
Parametric insurance coverage is a type of insurance contract that pays a pre-defined amount if certain pre-defined conditions are met. In recent years the use of captives as a mechanism for structuring parametric wind insurance products has grown, a trend that is expected to continue as the property insurance market hardens and companies are forced to take more risk, especially related to catastrophe exposures.
Captives provide the unique opportunity to structure innovative, customised programmes for companies seeking to address these immediate needs and provide insulation from market changes going forward.
“It is crucial to quantify the potential economic loss caused by a covered event and define this amount in the contract.”
Parametric insurance is gaining in popularity because it is seen as a simple and cost-effective alternative to traditional forms of insurance.
A wide variety of parameters may be set as the “trigger”, defining under which conditions the insured is paid. The trigger is typically directly related to the unique covered risk.
Examples of a trigger may be wind speeds reaching a certain level, hail of a certain size or the occurrence (or threat) of a certain category of hurricane. It is important to understand these parameters and the corresponding mechanisms that will be used to report them. Third-party experts and specific instruments used to measure the event play an important role in determining whether a trigger is met.
Risks commonly covered under parametric insurance are low in frequency and high in severity, resulting in a wide range in annual aggregated losses. Thus, it is important to understand the volatility of the unique risk and ensure proper funding and risk diversification is in place.
Due to the low probability of a claim in any given year, a multi-year policy may be structured.
Payouts in parametric insurance are not dependent on the actual damage. Once the event occurs and parameters are met, the payment, as defined in the contract, is issued. The payment may be a flat value or tiered values, each dependent on set parameters.
The defining characteristic is that the payout amount is specified in the contract prior to the event. This results in a quick and transparent payout and simplifies the claims process.
Thus, when designing a parametric insurance programme, it is crucial to quantify the potential economic loss caused by a covered event and define this amount in the contract. This involves a review of the economic impact of historical events and consultation with experts in weather and insurance pricing.
It should be understood whether this coverage will supplement or replace other coverage currently in place. For example, a parametric wind policy may supplement traditional property insurance by covering economic damages and other immediate needs not otherwise covered under the property policy, regardless of the actual physical damage.
This allows for the customisation of the amount of coverage to meet the unique needs of a specific type of business and the flexibility to decide which areas the payout may best be used.
The quantification of expected losses is typically straightforward once the trigger and payout terms are determined. Expected losses are commonly estimated by multiplying expected frequency by severity. Severity amounts are as specified in the contract. Frequency may be determined based on a review of historical data maintained by the insured or a third party.
For example, the National Hurricane Center records data for each known historical tropical storm and hurricane occurring since 1851. This could be a useful data source for programmes structured with wind speed as a trigger.
Additionally, catastrophe models may be useful in structuring the payouts and determining expected frequency.
Lori Ussery is an actuarial consultant at Sigma. She can be contacted at: firstname.lastname@example.org