Using Parametric Insurance Solutions to Insure CAT Risk

Why do we insure catastrophe risks such as earthquakes, windstorms, and floods excess of such large deductibles? Why can’t we provide ready and rapid access to capital to our clients in their greatest time of need? Why is so much information needed to underwrite CAT Risk and then again to pay a claim?

What if there was a better way? CAT insurance without a deductible? CAT insurance that provides capital within 10 business days? CAT insurance that can be priced within days, without needing to provide highly confidential or difficult to obtain information?

We are on the cusp of a new era of insurance for catastrophes, which will enable risk management professionals to provide simple, direct insurance where and when clients need it most. The solution, Parametric Insurance is a natural evolution of the capital markets embrace of Catastrophe Bonds.

CAT Bonds are an example of an Insurance-Linked Security which transfers a specific set of risks (generally catastrophe and natural disaster risks) from an issuer or sponsor to investors. 

In this way investors take on the risks of a specified catastrophe or event occurring in return for attractive rates of investment. Should a qualifying catastrophe or event occur the investors will lose the principal they invested and the issuer (often insurance or reinsurance companies) will receive that money to cover their losses.

Catastrophe bonds are used predominantly by insurance companies as an alternative to reinsurance in order to hedge risks of hurricane, earthquake, typhoon, windstorm, thunderstorm, hail and even life insurance related risks such as longevity and health insurance claims. 

More recently, other large buyers of reinsurance such as the New York Metropolitan Transportation Authority (MTA), and AMTRAK (the National Railroad Passenger Corporation that provides medium- and long distance intercity service in the contiguous United States) have also used CAT Bonds to provide ready access to capital for storm surge risk in and around Manhattan, a region where they have the highest concentration of assets and infrastructure. 

More recently, member countries of a catastrophe risk facility in the Caribbean received a pay out of US$29.2 Million within 14 days for claims associated with hurricane Matthew. 

While many insurers view CAT Bonds solely as a way to reduce their reinsurance costs, leading insurance companies are finding ways to leverage their existing capabilities and balance sheets by creating Parametric Insurance solutions to create new markets for their capacity.

One of the main challenges with CAT Bonds is that they take a lot of time to structure (often 90+ days), and are suitable only for large transactions due to frictional costs associated with investment bankers and legal advisers. For organizations that cannot benefit from CAT Bonds but want to capture the benefits of CAT Bonds, Parametric Insurance can be a very interesting solution. 

Like CAT Bonds, Parametric Insurance can be structured on an annual or multi-year basis (typically 3-year policies with annual installments). The insurance can be custom designed to provide coverage for an entire property portfolio, sub-segments or a property portfolio, for property damage or just business interruption, or even solely for contingent business interruption exposures arising out of an organization’s supply chain.

One recent innovative use of parametric insurance was to insure the earthquake risk associated with a large financial institution’s mortgage portfolio. The bank wanted ready access to capital in the event of a large earthquake so that they could fund their mortgage workouts. More typical uses of parametric insurance include funding or buying-down the earthquake and windstorm deductible for industries as diverse as real estate and large energy companies.

Unlike traditional insurance, no underwriting data is required and the insured does not need to disclose any information to underwriters regarding their property portfolio as the insurers are underwriting the probability of the event triggering coverage as opposed to trying to ascertain the damage that will be caused.

Since the triggers of coverage are critically important, most organizations will want to utilize an independent CAT modelling company such as AIR Worldwide to model the organization’s exposure at various triggers.

The models can then be utilized by the organization to optimally structure the trigger that is most suitable for them as opposed to the underwriters. For example, a typical program could be structured to provide coverage in the event of a 7.5 magnitude earthquake (trigger 1) within a 75-mile radius of San Francisco (trigger 2).

More complex programs can also be structured with more than two triggers, for example in the event of both an earthquake in one region and a windstorm in another region.

Since coverage is typically based on a magnitude trigger and radius, Parametric Insurance provides contract certainty. Simply put, if the triggering event occurs, payment is made. Adjusters are not needed as there is nothing to calculate.

Due to this simple structure, Parametric Insurance provides ready access to capital after a triggering event, with claims paid in full in as few as 10 business days of the triggering event. Funds can be utilized, as needed, for any purpose. 

Parametric Insurance can also be proactively disclosed to both regulators and to shareholders to address CAT risk concerns. Regulators will consider the insurance as support for capital adequacy models, and shareholders can be reassured that there is insurance in place in the event of a major CAT event.

Of increasing importance, Parametric Insurance is also consistent with and supports most organization’s enterprise risk management practices.

As more organizations seek solutions that better address their exposure to significant financial losses from CAT risks, Parametric Insurance solutions can be utilized to provide ready access to capital in the event of a catastrophe without the complexity and cost associated with CAT Bonds.

As more insurers and brokers begin to embrace Parametric Insurance solutions, the R(Evolution) will come when mid-market companies gain access to these powerful solutions to the CAT risks associated with their operations.

By Jamie F. Crystal, Executive Vice President at Crystal & Company

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