Risk Innovations: Captives & Parametric Insurance for Difficult Risks

Financial Model of Parametric Insurance within a Captive

The financial model of incorporating parametric insurance into a captive insurance company relies on predefined, measurable indices. When a certain event triggers these indices, the policy pays out a predetermined amount, providing immediate liquidity from the captive and thus to the parent company. These funds can then be used to cover various direct and indirect costs associated with the triggering event.

For example, if a company's captive insurance covers business interruption risk and incorporates a parametric cover for hurricanes, a payout would be triggered once a hurricane of a certain strength hits a predefined location. The payout amount would not depend on the verification of the quantum of an actual loss but rather on the parameters defined in the policy.

Advantages of Integrating Parametric Insurance into Captives

1. Quick Payouts: Parametric insurance policies provide fast payouts due to their objective and easily measurable triggers. This is particularly beneficial in case of a catastrophe when immediate liquidity is crucial for recovery.
2. Flexibility: The payout from a parametric insurance policy can be used flexibly, without the constraints of indemnity-based insurance. They can cover traditionally uncovered losses, deductibles, or indirect costs like loss of reputation or additional staff costs.
3. Risk Management: By combining traditional indemnity-based policies with parametric insurance, a captive can manage a broader array of risks and become more resilient to catastrophic events.

Potential Disadvantages

1. Basis Risk: One of the main potential downsides of parametric insurance is the basis risk - the risk that the payout does not match the actual loss. The payout is determined by the predefined parameters and not the actual damage.
2. High Premiums: Parametric insurance can sometimes carry higher premiums than traditional insurance due to its quick payout and broad coverage. 

Captive Case Study: Parametric Insurance for Contagion

An SRS client derives all their revenue from livestock, so an outbreak of any disease affecting the animal population will have a significant negative impact on its earnings and brand reputation. Contagion outbreaks in their continent have occurred for decades, at times devastating the livestock sector and causing bankruptcy for many companies in the supply chain.

With no reliable commercial market for this type of risk, SRS developed a unique solution that integrates parametric insurance coverage into a captive insurance company to provide coverage.

Risk Radar: Tracking Outbreaks

The specific contagion is a contagious viral disease affecting both domesticated and wild livestock. It spreads rapidly through contact with infected animals or contact with contaminated pens, trucks, clothing, or feed. There is no vaccine available and there is no risk to human health.

The company’s home territory has been disease free since 1995, but continually tracking outbreaks revealed that there has been a resurgence within the continent. As an example, one country was disease free between 1986 and 2018 but reported 643 outbreaks between 2018 and 2019, Similarly, other previously disease-free countries have recorded outbreaks following long periods of being contagion free. It became clear the client needed to proactively address the risk to avoid potential financial failure.

The disease is predominantly spread through wild animal populations and as that population has grown and migrated, associated disease outbreaks began spreading towards the company’s home territories. There have also been random jumps of outbreak, typically caused by illegal importation of animals and animal products.

How the Policy Works When an Outbreak Occurs

Parametric policies are designed to kick in when a specified trigger event occurs (such as Contagion), but the event must be validated by an independent entity (typically called the ‘Calculation Agent’) before the agreed upon payout is settled. An example of an objective and reliable data source for an animal-based outbreak would be the Ministry of Agriculture, Fisheries & Food within the European Union (EU)

Within the EU, the European Commission (EC) has established standards for what local regulatory entities (such as the Ministry of Agriculture, Fisheries & Food) need to do when an outbreak occurs. If an outbreak has been officially declared, regulators must establish zones to help curb its spread and as such SRS was able to design various verifiable triggers and associated Payouts awards reflecting the degree of impact, as an example:

The Implicated Zone: Perception of Infection

Including a measure of protection against potential damage to reputation and shareholder value within a parametric policy required detailed negotiations with commercial underwriters. While not the policy’s primary purpose, this aspect of the coverage reflects the reality of what happens to a company’s value when the public believes the outbreak is not under control. Quick access to claim funds allows the company to implement a crisis communication program, which may require immediate and costly public relations campaign(s).

Getting it Done: Program Design Highlight

A parametric may be a viable way to bridge a lack of data or alleviate complex claims management, but equally parametrics could be an avenue to incubate unique or difficult risks within a policy form that can attract the commercial markets. It can be challenging to describe what you want to accomplish if you are proposing something entirely new and so SRS has found that one key to getting it done is using smart analogies to other known coverage types.

In the above case study, SRS have showed underwriters that the proposed contagion parametric policy was directly analogous to windstorm parametric policies. Similarly, SRS have supported a proof of concept for a unique agri-risk product that was analogous to a simplified product recall coverage to establish underwriters’ interests.