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 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 quickly assessed, and not on actual losses, which are harder to quantify, claims can be paid much faster.

Parametric insurance can best be illustrated with the Caribbean Catastrophe Risk Insurance Facility.

The Caribbean Catastrophe Risk Insurance Facility (CCRIF) by the World Bank sells disaster insurance to governments of the Caribbean nations that are frequently subject to hurricanes. The CCRIF uses donor-funded capital reserves, reinsurance, and catastrophe bonds to reduce costs through economies of scale and risk pooling.

Countries buy the amount of insurance based on their level of catastrophic risk and their ability to pay. 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 claim payments. The ultimate legal and institutional structure depends 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.