Parametric Insurance

Parametric insurance, as a form of catastrophe insurance, is emerging as a new way to provide prompt budgetary support to governments subjected to major natural disasters, like hurricanes and earthquakes, especially in small countries that are subject to frequent disasters, such as the small nations in the Caribbean region. The payment of claims is not based on actual losses, but on parametric triggers, which are specified intensities of the natural disaster in a specified location as measured by an independent agency. Since the payment of claims depends on the parametric triggers, which can be readily assessed, and not on actual losses which would have to be quantified, claims can be paid much faster.

There have been at least 2 facilities with different approaches to providing parametric insurance: GlobeCat and the Caribbean Catastrophe Risk Insurance Facility.

GlobeCat was developed by Swiss Re to help people in natural disasters, such as floods, earthquakes, and severe storms as a more responsive way to help people in need rather than relying on charitable help, which is often slow to trickle in.

GlobeCat is divided into 3 tranches, with 1 tranche covering windstorms in the United States, another covering earthquakes in California, and the LAQ tranche covering earthquakes in Guatemala and El Salvador.

Payment is made based solely on the level of the natural disaster in a particular locale, such as the amount of earth-shaking at a particular location. The risk modeling company EQECat was used as the calculation agent as well as for the initial risk analysis.

The trigger for the tranche covering Central America is based on how much of the population is exposed to a certain earthquake intensity as measured by an independent index.

GlobeCat is a special-purpose vehicle (SPV) with initial funding of $85 million USD. The SPV then sells catastrophe bonds that cover specific events in specific geographical areas. The main target market consists of charitable organizations, corporations, and even governments as a way to leverage their aid, where each dollar of donations can yield $45 of aid.

The 3 tranches pay a coupon based on the 3-month LIBOR rate plus a variable number of basis points for each of the tranches.

Another approach to helping countries survive disasters is the development of the Caribbean Catastrophe Risk Insurance Facility (CCRIF) by the World Bank to sell disaster insurance to governments of the Caribbean nations that are frequently subject to hurricanes. The CCRIF is using donor-funded capital reserves, reinsurance and catastrophe bonds, which will reduce costs through economies of scale and the pooling of risks.

Countries buy the amount of insurance based on their level of catastrophic risk and their ability to pay. Premiums range from $500,000 USD to $2,000,000 for coverage ranging from $20,000,000 to $80,000,000. It is hoped that premiums can be reduced by extending coverage to other small nations, such as those in the Pacific region, that are also subject to frequent disasters. The primary objective of the facility is to provide prompt budget support to affected governments—not to cover all damages, which will still require donations or private insurance.

The CCRIF will have an operation manager who will collect the premiums from the insured countries, buy reinsurance, manage the portfolio, and monitor the payment of claims. The ultimate legal and institutional structure will depend on the operational experience and the reinsurance market—what reinsurers will require before investing in the facility.

Payments for claims are based on parametric triggers. Event coverage is limited to specific events, in specific areas, and for a specific amount of time. The number of events covered may also be limited within the specified time. The major problem in determining premiums is to develop risk models that can accurately assess the probability of either earthquakes or hurricanes for each of the participating countries.

For instance, the parametric hurricane insurance contract pays a specified amount if the hurricane reaches a certain category level in the Saffir-Simpson scale in a specified region and the wind speed reaches a specified minimum in a specified location, such as the capital of the country, where a hurricane would do considerable damage. The scale of the hurricane would be determined by an independent agency, such as the National Hurricane Center (NHC) of the U.S. National Weather Service. The insurance policy coverage would be capped, not by the number of hurricanes, but by the aggregate liability for the year.