Technology expands parametric risk transfer applications

Connected City
Advances in data science, sensor technology and artificial intelligence is broadening the application of parametric risk transfer products, such as insurance policies, which are becoming increasingly popular as a tool to reduce volatility of balance sheets and earnings.

Parametric risk transfer products can address non-damaging risks that might not be covered by an existing risk management programme, such as business interruption, supply chain impacts, and fluctuating business costs. The products pay the protection buyer, such as an insured, when a defined event occurs. A product could, for example, be triggered if 12 inches of rain falls during a certain period of time, say 48 hours. If the risk transfer product takes the legal form of an insurance policy, the policy will pay out a pre-determined amount although the insured will need to produce some evidence of principal indemnity loss caused by the non-damaging risk addressed by the policy.

An independent entity such as a data analytics provider or a national meteorological agency is defined in the contract and acts as the transparent third-party arbiter of, in this case, the weather exposure, in order to minimise any potential claims disputes between the protection buyer and seller. Triggers for parametric weather and natural catastrophe products can range from sustained wind speeds, rainfall volume, river flow, seismic activity or temperature levels, amongst others.

“One of the advantages of parametric risk transfer is that it requires significantly less actual loss adjustment before a claim can be paid. It makes this product easy to understand and allows for a quick payment of claims,” says Kavit Khagram, Vice President of Lockton Re Advisory.

A buyer of a parametric re/insurance policy still needs to evidence the loss that they have suffered as there is usually an excess included in parametric insurance policies, but the excess is much lower than in traditional insurance policies.

“There is still some loss adjustment needed, but it is generally a much simpler process when compared to the traditional insurance analogue,” Khagram adds.

The attributes of parametric risk transfer make it particularly attractive for developing markets where underwriting data may be scarce, unavailable or unreliable. An additional advantage of the product is that pricing is intuitive and reflects the frequency and severity of the underlying weather exposure relative to traditional insurance products.

“For weather-related triggers, all a product needs is an accurate data source for example from weather stations, military bases or other data providers. Data is typically available widely and at reasonable cost,” Khagram explains.

Fruit and vegetable producers, for example, can protect themselves against a weather-related bad harvest. Similarly, renewable energy producers can protect their revenues against low wind and sunshine levels or drought in the case of hydroelectric power producers. Cinema chains – or the film producers themselves – may want to protect their income against adverse weather outcomes affecting their business.

Weather events may be the obvious triggers for parametric risk transfer products, but the potential for applications is vast and new indices based on newly available datasets are regularly being researched and deployed. Some innovative solutions for example include non-physical damage risks such as reputational risk, non-physical damage business interruption losses (including supply chain), cyber-attacks and pandemics.

The Internet of Things (IoT) and the spread of sensors in the economy is further expanding the availability and provision of reliable and accurate data feeds that can serve as triggers for parametric risk transfer products.

“All it needs is a clear correlation between the selected trigger and the exposures of the protection buyer,” Khagram explains.

All it needs is a clear correlation between the selected trigger and the exposures of the protection buyer.

Reducing risk exposure and therefore the volatility of a balance sheet and earnings can have many benefits, for example, making companies more attractive for investors.

“If a renewable energy company is considering building a new solar park, for example, and is looking for debt capital investment, a parametric risk transfer product can be very effective at protecting project revenues against low levels of sunshine, and therefore its investors’ coupon, significantly improving the feasibility of the venture,” Khagram says.

“All investors prefer stability in earnings and parametric risk transfer products present an opportunity to make a company more attractive for capital investors and lenders,” he adds. 

For further information please contact:
Kavit Khagram
Vice President
Lockton Re
Tel: +44 (0)20 7933 2391
Email: kavit.khagram@uk.lockton.com

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