Parametric versus traditional indemnity insurance products

12 July 2017

Businesses that need a comprehensive risk management strategy have a growing interest in parametric insurance products.

Ryan Fitzpatrick, COO, Jardine Lloyd Thompson Capital Markets

Parametric insurance is a type of insurance that does not indemnify the pure loss, but ex ante agrees to make a payment upon the occurrence of a triggering event.

The reason is simple. With a parametric product they can cover risk perils – such as contingent business interruption – that are either not covered at all or are not adequately covered by traditional indemnity-based insurance policies.

Regulatory risk protection

Risk perils that could be protected against with a parametric cover can even include regulatory risk.

Imagine a cocoa producer in Costa Rica that’s exposed to a category 4 (or greater) hurricane making landfall and deforesting a large portion of their plantation.

Even if the plantation or processing operation is not damaged, they might still not be able to get their product to the market.

The company is also concerned the Costa Rican government could increase the tax on them to pay for damages in resort areas to secure the country’s tourism revenue.

A ‘Cat in the Box’ parametric structure type – where the catastrophic event happens within a delineated area – could properly protect the Costa Rican cocoa producer from both those contingent events.

Parametric products can hedge regulatory or political risk in many parts of the world, providing a war chest to corporations and insurance companies that allow them to deal with political or governmental actions.

Parametric triggers

In 2015, California experienced one of the worst droughts in its history. 

The drought was so severe that the State of California ‘requested’ several orchards to abandon 1,000 acres each and to stop irrigating. Subsequently, almond growers suffered a hit to their income statements. 

One particular almond producer shuttered thousands of acres costing $10 million in revenue per 1,000 acres.

If the orchard had a bespoke weather solution in place with a parametric trigger based on lack of rainfall at the orchard’s location, the farmer likely would have had the resources to smooth the effects of the drought.

In a similar way, parametric products can be structured by the capital markets to be part of any government’s plans to help them deal with climate change effects. 

They can be deployed as a disaster mitigation tool in the event of a catastrophic event, or use a non-catastrophic weather trigger.

Parametric triggers for this type of scenario have real advantages. As an event unfolds, the funds are quickly available to aid in the recovery of the region and to assist citizens. 

Other catastrophe mechanisms can take months or even years to work through the lower levels of government.

Parametric potential

Clearly, parametric triggers have wide potential for mitigating risk and speeding up the refunding process.

While indemnity is still the preferred structure for risk transfer products, the claim settling process is sometimes long and arduous for the purposes of some clients.

Parametric products are ideal for corporate entities who want to hedge against natural catastrophe or business interruption risks without having to go through the traditional insurance claim process. 

But risk-linked securities and trigger mechanisms often work best when they are structured to look at exposure through a holistic lens without bias to one trigger or another. 

For instance, a product can have a secondary trigger to increase cost-efficiency; such a trigger could be the price of a commodity.

Indemnity and parametric both have their places in the hedging toolkit and indemnity products are still the best way to hedge actual monetary loss.

But with the advances being made in modelling and quantitative analysis, we can look forward to more basis risk being driven out of parametric products, increasing their appeal even further.

Download Risk Perspective

For further information, please contact Ryan Fitzpatrick on +1 646 362 4654 or email ryan.fitzpatrick@jltcapitalmarkets.com