Education key to mitigating basis risk in parametric policies

Miller has put a “high degree of focus” on educating its insureds on basis risk associated with parametric insurance policies, Alice Glenister, head of parametric solutions at the re/insurance broker, says.

In an interview with Insurance Day, Glenister explains basis risk is more prevalent in parametric insurance owing to the policies’ predetermined payouts at certain trigger thresholds. Glenister joined Miller in March from Mastercard, before which she was a parametric underwriter at Generali Global.

Miller’s solution has been to try to understand exactly what insureds need a parametric insurance policy to do, and to make sure the payout structure reflects the potential damage they would sustain should that given event occur.

Unlike traditional indemnity-based cover, parametric insurance pays out a predetermined sum if a specific event or trigger occurs, such as if windspeed or rainfall is recorded to have breached a certain threshold.

Recent growth 

The concept of parametric insurance dates back to the late 1990s, but its recent growth has been spurred by the increasing amount of data insurers can use to verify a parametric claim.

These policies are positively pre­disposed to weather and climate-related events for exactly this reason, Glenister stresses, as insurers can call on thousands of accredited datapoints to assess claims to ensure policy conditions are met.

However, all of this can amplify basis risk. One commonly cited example is home insurance that covers fire damage but excludes fire damage caused by extreme weather events. While parametric insurance would provide a reliable payout if the predetermined condition is met – the house fire – it might fall short of covering the actual costs of the trigger event.

“In order to mitigate basis risk, we make sure we fully understand the insureds’ needs and that the parameters selected closely align with their exposures,” Glenister says.

Basis risk needs to be mitigated in both directions, both negative and positive, she continues. While not common, positive basis risk – where payouts exceed actual losses and risks are underpriced – have occurred in recent years, particularly in the agricultural sector.

For example, Oxfam successfully negotiated a payout from Sri Lankan insurer SANASA to cover policy­holders whose crops had been affected by extreme drought, despite short bursts of rain exceeding the parametric policy’s maximum rainfall threshold.

“If your roof has been blown off by a hurricane, you don’t want to wait a year for the loss adjuster to come round. You want to repair your roof. We are trying to give people the resources they need to recover quickly. That’s why parametric insurance is so powerful” 

^{Alice Glenister
Miller}

Glenister adds that, in some cases, Miller designs a “stepped payout policy” to mitigate basis risk. This is designed to pay out a larger amount of money for more extreme events, rather than a binary payout.

“We want to make sure payouts reflect damage ratios,” says Glenister. “You wouldn’t get a 100% payout for a Category 3 hurricane, but you would for a Category 5. It’s important that we’re not creating binary payouts.” 

It is incumbent on brokers to explain the benefits of parametric insurance to support its continued growth. “If brokers don’t understand the upsides, there will be reduced demand… hindering growth and innovation,” she says.

Lack of traditional capacity

And parametric policies have been a welcome form of innovation for the insurance sector over the past two decades, Glenister points out. She argues a prevailing lack of traditional capacity – the maximum amount of risk indemnity insurers can underwrite based on the capital they have available to cover claims – is being stretched thin in certain markets by the increasing frequency and severity of certain natural catastrophe perils. “This is why it’s important to think about non-traditional means to manage risks,” she says.

This is particularly the case for perils such as Florida wind risk, where more severe weather events have left the traditional market struggling to find capacity.

“It’s quite hard to get capacity for wind risks in Florida the closer you get to wind season. The sad reality is that climate change is making events more frequent, and parametric insurance provides us with ways to transfer risk, even in sophisticated markets like North America.”

The principal benefit of a parametric insurance policy in the case of a weather event is to cut the time between claims and payouts, she says, while traditional, indemnity insurance provides no certainty a claim is covered, and payouts can take months or even years.

“If your roof has been blown off by a hurricane, you don’t want to wait a year for the loss adjuster to come round. You want to repair your roof,” Glenister says. “We are trying to give people the resources they need to recover quickly. That’s why parametric insurance is so powerful.”

The combination of trigger-based policies and swift payouts gives parametric insurance the potential to work in several markets, including agriculture, cyber and marine, she adds.

Moral hazard

As well as basis risk, brokers should also educate their clients about the way parametric insurance can reduce moral hazards, by incentivising policyholders to mitigate risks up to their first trigger indexes. A moral hazard is the probability the insured may engage in riskier behaviour or neglect risk management practices because the payout is triggered by predefined parameters rather than actual losses.

Miller partly mitigates against moral hazard with its stepped payout policies, which encourage policyholders to carry out maintenance or take mitigation measures.

Independent third-party data has a significant role to play in mitigating moral hazards, Glenister says. “It’s very important to ensure that neither the insured nor the insurer can influence the reporting of an event to inflate or deflate final payments,” she adds.

The insurance market is only scratching the surface of what parametric insurance products can do, Glenister stresses, but she is confident they can only continue to develop over the next several years. Notably, digitalisation of global business means parametric solutions are no longer the preserve solely of large corporate clients.

“Because data is ever improving the way we’re measuring risk, the way we can gauge risk, the way that we can handle large quantities of data, [parametric] is only going to get better and better,” she concludes.