Tuesday, May 21, 2024

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Slow uptake, but parametric products can be “perfect fit for captives”

  • Parametric policies issued by captives rare
  • Captives can play role in reducing and absorbing the basis risk of parametric products
  • Regulators increasingly comfortable with captive parametric policies

Parametric products are the “perfect fit” for a captive due to their direct access to internal company data, while the policy’s automatic pay-out function also lends well to captive utilisation.

Having the ability for claims to be paid automatically streamlines the claims process and removes the need for large internal or external claims teams.

Regulators have also softened their stance on parametric cover, with some introducing specific legislation to facilitate this type of policy for captives.

Parametric products have most commonly been utilised for natural catastrophe risks such as flooding and earthquakes, but the possibilities span across many different risk types, such as cyber and even director and officers.

Thomas Keist, global captive solutions leader at Swiss Re Corporate Solutions, told Captive Intelligence that a captive is best suited to get the analysis right when it comes to a parametric policy due to its ability to get direct and full access to corporate sources of data.

“No other insurer has access to that data,” he said. “That’s why I believe strongly that captives can play a much bigger role in getting the data right to be able to buy parametric insurance.”

Dr Avi Baruch, co-founder and chief operating officer at Previsico, said some organisations have large quantities of data that is “incredibly valuable” for improving the forecasting of parametric products.

“And so, we worked very closely with them using their data to make sure that the products are well-tailored,” he told Captive Intelligence.

Previsico is a parametric technology company that provides clients with software in order to help mitigate and prevent losses caused by natural damage.

“We’re focused on pluvial flash flooding, surface water flooding, and the sorts of events that catch people off-guard and our technology has a number of different parts to it,” Baruch said.

“The main part is live simulation software that simulates where flooding is expected to occur in the next few days, using a wide range of different data, land cover geology and rainfall forecasts, which is then also complemented on the ground with on-site sensors.”

As the market hardens flood insurance is becoming harder to come by, increasing the importance of loss prevention.

“Insurance is a vital but small part of a company’s wider risk management strategy,” he added.

“Especially for a captive, you’ve got your total cost of risk, but also the cost of loss below the deductible or above the deductible.

“Then you’ve also got ongoing risk management, business interruption, loss of reputation, all those other impacts around the events that aren’t necessarily covered by your insurance policy, and as the deductibles rise, people need more products around loss prevention.”

Although captives are considered a strong fit for parametric polices, it is uncommon for a captive to be utilised for this type of cover, though captives utilising parametric insurance is on the rise.

“We expect that the demand and also the supply of parametric insurance to increase especially in the natural catastrophe area,” Keist said.

Steve Bauman, global programmes and captive director in the Americas at AXA XL, said he is seeing rising demand for parametric products.

“We’re putting more talent in the US into that product, so it’s a growing area for us,” he told Captive Intelligence.

“I think it’s a very natural and beneficial product to share with the captive, so I have big aspirations for captive utilisation.”

Bauman said that the ease of the claim settlement is a “great appeal” because the event either happens or it doesn’t.

“That has an appeal to clients who buy that kind of cover as it’s not a drawn-out process of claims adjustment.”

He believes some companies see parametric products as a discretionary spend, and if the captive takes a portion of the risk, then it reduces the challenge as the captive is then paying for a percentage of the risk itself.

“If it doesn’t happen then everything is not lost as the captive gets a proportion of the money,” he said.

Andy Hulme, director of underwriting at Strategic Risk Solutions (SRS), revealed that the company recently formed a captive for a client with a particular risk that they could not buy insurance for.

In this instance, a parametric policy was deemed the most appropriate solution.

“We started with a small trigger with the intention that we can grow the pay-out and the triggers over time to become more appropriate for the true exposure of the company,” Hulme told Captive Intelligence.

Regulatory landscape

The attitude of regulators towards parametric insurance is also changing with some jurisdictions introducing specific legislation.

“If you go back, regulators were a little bit concerned about the potential of basis risk inherent to a parametric policy and whether it’s actually more of a derivative because there’s a potential upside for the insured,” Hulme said.

“But I think moving forward, underwriters have undertaken work to make sure that the basis risk is mitigated or minimised as much as possible.”

Connecticut Governor Ned Lamont signed Public Act 23-15 in June, including new regulation that permits captives to accept and transfer risks through parametric contracts.

“The Bill, championed by Commissioner Andrew Mais of the Connecticut Insurance Department (CID), marks a significant milestone in advancing a business-friendly regulatory environment that encourages innovation and supports the growth of captives to provide more options for businesses to manage their risk,” the CID said.

Fenhua Liu, assistant deputy commissioner of captive insurance at the State of Connecticut, told Captive Intelligence that the Department decided to introduce this regulation because many carriers do not have enough capacity, and risk owners are struggling with the cost of insurance.

“Our department of insurance realised this, so we tried to clarify our legislation to provide more flexibility to use alternative, technology-driven, innovative products,” she said.

Liu revealed that the state has a couple of companies that are specialised in using parametric solutions to transfer risks and “we have some more large companies looking at captive solutions with parametric products”.

“Risk owners and takers can use these transparent and cost-efficient services that include the modelling, the underwriting and the payment contracts with triggering events to transfer different layers of risks to commercial insurers and investors,” Liu said.

Sandy Bigglestone, deputy commissioner for captive insurance at the Vermont Department of Financial Regulation, noted that captives in the state can enter into parametric contracts, “simple as that”.

“When you look at the Securities and Exchange Commission (SEC) requirements, they categorise them as more of a derivative,” she told Captive Intelligence.

“We’ve put into law that a captive can enter into a parametric contract and that was intended for pure parametric contracts in an SEC sense.”

She said the rest of Vermont’s reinsurance laws do not prohibit the captive from entering into a parametric contract for insurance.

“I would like to figure out a way to clarify that a little bit more,” she added.

Absorbing, mitigating basis risk

When a company has a parametric insurance product, assessing the actual loss sustained is not required as there is an automatic pay-out of a pre-agreed amount once specific trigger event conditions are met.

For example, if a client owns a concrete building that is able to sustain an earthquake up to a magnitude 6.0, a parametric cover can be designed to start responding from that magnitude event onwards.

“However, in the event of the building sustaining a damage at a 5.5 magnitude, this loss is not covered under the parametric policy since any payment will only be triggered from a magnitude 6.0 onwards,” said Jan Bachmann, head of innovative risk solutions EMEA at Swiss Re Corporate Solutions.

“That’s what makes it very simple and objective, but at the same time, very often it pays out $10m, but maybe the actual loss was more, or it was less, or it was something in between.”

“So, you have a mismatch, and we call this mismatch the basis risk.”

Swiss Re has developed two different approaches in which the captive can be utilised in order to minimise the basis risk for parametric policies.

“For option A the corporate client is covered through its’ captive on a traditional indemnity all risk basis,” Bachman said.

“The usual traditional indemnity insurance may include some heavy natural catastrophe risks such as California earthquake.”

The captive then has the possibility to carve out earthquake California risk, for example, and protect itself on a parametric reinsurance basis.

“By doing so, the captive will carry the basis risk as the ultimate entity buying the parametric cover,” Bachmann said.

A captive can generally only do this if it is confident that its basis risk is small and that it has enough capital to absorb it.

If a company picks the second option, instead of the client being insured on an indemnity basis, the corporate client also decides to be covered on a parametric basis.

“Therefore, the captive will provide a parametric policy to the client and, as in option A the Captive reinsures also through a parametric policy,” Bachmann said.

The basis risk has now moved from the captive to the corporate client, the original insured. 

Bachmann explained that since captives themselves often lack knowledge or resources on transforming risks into parametric insurances, “specialists like us are filling the need for risk modelling and solution design”.

“This is then usually combined with our fronting capabilities,” he added.

A risk manager for a company that recently began utilising its captive for parametric risk told Captive Intelligence that the main challenge was convincing internal stakeholders of the perks of the policy.

“It’s about being able to communicate the benefits and how it fits to the company’s overall strategy, and how it’s bringing down the cost of the overall programme,” the risk manager said, speaking on the condition of anonymity.

“A company needs to look at everything holistically before you make that decision.”

The risk manager said that there were market restraints when the company originally started looking at incorporating a parametric policy.

“It was a very hard market, and the parametric approach gave us another tool where we could use half the capacity while creating some reductions in our overall cost to the programme.”

Outside natural catastrophe

When clients think of parametric products, it is common to think of them in relation to natural catastrophe risks such as storms, flooding or earthquakes.

However, there are significant other possibilities for how this type of cover can be used.

Hulme said that for both cyber and directors and officers cover, there are really “interesting opportunities” where a client could take a different perspective on the traditional insurance play.

“We could have a parametric trigger that is impacted by the threats or by the accusation of a cyber-attack or some kind of wrongdoing in the directors and officers space, and then that could then trigger an investigation cost.”

Bachmann noted that parametric insurance has “long since outgrown its teenage years and has developed into fully fledged and available insurance solutions” even for high frequency events such as crop shortfall in the agriculture space or temperature volatility impacting energy players.

“And it does not stop there, airline delays, retail business footfall and supply chain disruption are within the realm of possibility thanks to ever evolving data and tech,” he said. “Routing these risks through the captive is a good path and especially for frequency. It is risk that is closer to the money and may be preferred to be absorbed by the captive.”