Parametrics - Building A Better Trigger

Parametric insurance products are increasingly being used as an alternative to traditional insurance to address the "protection gap" and increase the speed of insurance payments, particularly in the face of natural catastrophes. Advances in modelling of parametric insurance triggers have the potential to decrease the basis risk of parametric products, and make them more attractive to both insurers and their insureds.

The term 'basis risk' can be used to describe imperfect hedging; when the amount by which the exposure in a futures contract differs from the projected value. In the catastrophe bond market, basis risk is the risk that a cat bond may not be triggered, or inadequately triggered, even where the sponsor has suffered a loss.

In the insurance context, basis risk is usually used to describe the amount by which the loss to be indemnified under an insurance contract differs from the pre-modelled loss anticipated when the policy was underwritten.

When insurance cover is indemnity-based, recovery will be determined by reference to the actual loss; in theory there should be very little basis risk. It may be claims handlers, loss adjusters or lawyers who ultimately determine what is covered according to the application of contractual terms to the facts on the ground. Discrepancies between insurer and insured in anticipated recoveries will usually lie in divergent understandings of what was in fact covered according to the policy's terms and conditions.

With a parametric insurance product, the trigger for payment is a set of pre-defined objective parameters, such as the force of a hurricane or the magnitude of an earthquake. The arbiter for insurance coverage effectively becomes the parametric trigger itself: if the parameters are met, payment is made.

One of the benefits of parametric insurance products is the potential speed by which payments are released when the defined parameters are met. Disputes about coverage are also much reduced.

However, the potential for basis risk remains the major and oft-cited downside to parametric insurance products and for insurance linked securities with a parametric trigger. One example of imperfect parametrics came in the experience of the African Risk Capacity (ARC), a specialised agency of the African Union, in Malawi.

The ARC uses a bespoke modelling tool called Africa RiskView to interpret a range of weather data – including rainfall estimates, satellite-based rainfall information and information on...