Parametric or index-based insurance is becoming increasingly popular with private companies, national governments and public-private partnerships due to the elegant simplicity of the solutions. Based on an independent parameter or set of parameters that are correlated to a client’s risks, it differs from indemnity insurance in that claims payments are triggered automatically once an agreed-upon threshold is reached.
Q: When were parametric solutions first developed?
A: Parametric solutions are a relatively new development. The first parametric or index-based products were developed by energy companies and commodities traders in the late 1990s. The key enablers were the increasing availability of high-quality, reliable and granular weather data, more powerful computers, and advances in modelling techniques. With these data and tools, companies whose profitability was influenced by the weather could now better understand and model the relationship between cost/revenues and average daily, monthly or seasonal temperatures.
What also emerged from these early modelling efforts was the recognition that, in the right context, weather could be quantified and indexed. And based on these index values, weather could be “packaged” as a tradeable commodity.
The first weather derivative trade was made in 1997, and in 1999 the Chicago Mercantile Exchange introduced trading in weather futures and options. Companies in a range of sectors now had financial instruments for lessening revenue/cost volatility associated with atypical weather.
The same concepts were then used to create index-based solutions for mitigating weather risk, especially those related to natural catastrophes. In 2006, AXA issued its first parametric insurance policy; this was done with the World Food Programme to cover droughts in Ethiopia. While there was limited activity in this area over the following several years, that changed in 2014 when a parametrics team was created within AXA Corporate Solutions. In 2017, AXA established a separate, standalone entity, AXA Climate, dedicated to creating and pricing index-based solutions.
Q: What are the components of parametric insurance?
A: One of the things I always find striking about parametric insurance is the elegant simplicity of the solutions. These coverages are based on three factors:
- The index value; one or more variables that are tightly correlated with the client’s revenues or costs.
- The threshold level/deductible; the point at which the insurance kicks in. These can be structured in different ways. In a purely binary structure, the full limit is paid when an index value above or below a pre-defined threshold is recorded. Alternatively, the payout size can be linked to the severity or magnitude of an event; for instance, a Category 4 cyclone triggers XX% of the limit while a Category 5 cyclone pays YY%. With a linear structure, the payout size increases incrementally as the index value changes.
- The limit; the maximum payout that will be made. And for it to be insurance, the limit has to be less than or equal to the client’s actual losses.
Q: What kinds of organizations are using parametric solutions and how are they being used?
A: Parametric solutions are primarily, although not exclusively, used to mitigate weather risk, and as such, are relevant to many organisations in both the public and private sectors.
Some of the earliest parametric schemes were introduced by national governments. China and India, in particular, have been pioneers in using parametric insurance to protect small farmers from extreme weather.
A typical scheme encompasses all of the farmers in a group of villages or districts where the climate, crop production and yields are similar. The index is derived from the relevant local factors impacting yields like precipitation, temperature, wind speed and solar radiation; it can also be based on a single variable or some combination of variables. India, for example, has a programme that covers 35 crops in 17 states. It’s based on a combination of weather parameters and area yield indices.
When the threshold value is exceeded, individual farmers are compensated directly according to pre-agreed terms. These can include the extremity of the event, the size of the farm and the value of the crops. In some cases, the payouts will be made to the banks that extended credit to individual farmers so that their loans don’t go into default. Either way, the farmers have the financial resources they need to plant a new crop.
And as the world confronts the prospect of more extreme and unusual weather events, many governments, global institutions like the UN and World Bank, development banks, major aid organizations and re/insurers like 色多多视频are working together to create practical and affordable solutions for improving resilience and sustainability. While these usually incorporate several complementary elements, parametric insurance is often a prominent component in the overall programme because of the speed of the payouts after a major disaster. The World Bank, for example, has facilitated the set-up of parametric earthquake bonds worth US$1.6 billion covering the Pacific Alliance members Chile, Colombia, Mexico and Peru.
There is also rapidly growing interest in some parts of the world in using parametric schemes to help close the protection gap – the difference between losses covered by insurance and total economic losses. AXA XL's Emerging Markets team, together with AXA Climate, is looking at how parametric solutions could further support the work they are doing in different countries to protect local and regional economies from natural catastrophes and promote food security.
In the private sector, parametric insurance enables companies to mitigate the impact of weather anomalies including excessive heat, rainfall, cold and drought, which can reduce revenues and increase costs.
Not surprisingly, much of the growing interest in parametric insurance is coming from industry sectors that are most exposed to weather risk, including:
Agriculture: In addition to public schemes designed to protect smallholder farmers, large agribusinesses also use parametric covers to mitigate weather risk. Here, too, the coverages and indices are based on the crops/livestock being raised and the location.
So in cotton-producing regions in Africa, for example, agribusinesses are purchasing parametric solutions triggered by drought. In France, on the other hand, vineyard operators and fruit growers are protecting their revenues with temperature-based frost covers.
Renewable energy operations: The applicability of parametrics in this sector is not surprising given that some facet of the weather is the raw ingredient in the product.
For solar energy plants, satellite solar radiation data is used to model energy production. The index can also incorporate heat – temperature as well as solar radiation – to reflect the fact that solar plants are less productive at higher temperatures; that’s especially relevant, for instance, with solar energy installations in the Middle East and Northern Africa.
With wind farms, the index is derived from satellite wind data. For hydropower operations, precipitation for the catchment area and/or streamflow data are used to create the index.
Construction: In some Middle Eastern countries, for instance, work has to halt once temperatures rise above a certain level. Alternatively, very cold temperatures will slow down concrete strength development and render it unfit for purpose. In both cases, a temperature-based index can be used to help construction companies absorb the extra costs that result when a project is delayed by extreme weather.
Other industry sectors exposed to weather anomalies include:
- Tourism and leisure: Extreme heat or cold can mean fewer visitors to theme parks, sporting/cultural events and tourist attractions.
- Transportation: In the case of prolonged or excessive cold and snow, airline companies can face increased costs for de-icing. Shipping companies face extra expenses when river heights rise or fall.
- Apparel: Sales of seasonal clothing items like winter coats or bathing suits can be affected by unusually warm or cold temperatures.
Q: What are the benefits or advantages of these solutions?
A: I regularly mention five characteristics of parametric insurance in discussions with potential public and private sector clients.
The first is that it’s objective. Because every parametric solution includes an index value(s) derived from independent, third-party data, payouts are triggered automatically when pre-agreed threshold levels are exceeded. That means the policy is not subject to interpretation or conditions or caveats, and the client knows in advance exactly what the payouts would be at each index value.
The second is the speed element. Once a threshold is reached, claims can be paid in days or, at most, weeks. These two attributes, objectivity and speed, are especially meaningful for governments looking for protection against natural catastrophes. There is considerable evidence showing that the overall impact of a natural disaster – both in terms of human suffering and economic damages – is lessened significantly when governments and private investors are confident payouts will be made shortly after a catastrophe occurs.
Also, as blockchains become used more widely, we’ll be able to embed the parametric triggers into the payment system so that payouts are made automatically and potentially in seconds.
The third is that parametric solutions are tailor-made. Each policy covers specific locations/facilities defined by the client, and the individual programme structures – index values, payout formula and coverage limits – are customized to the client’s strategic objectives, risk appetites and budgets.
The fourth is that parametric insurance is available globally. In some cases, it can be challenging to cover a particular risk because it’s located somewhere that is hard to get to or because the local insurance market is not well developed. With global satellites, we have weather data across the Earth; we can develop coverages for wherever they’re needed.
Finally, parametric solutions are cost-efficient. While we need highly skilled people on the front-end to develop the policy, we don’t need appraisers, attorneys or other technical specialists to resolve claims. And because it’s based on objective third-party data, coverage disputes, as well as potentially fraudulent claims, are not an issue.
Q: What’s involved in building a parametric solution?
A: While the end product may be simple, creating an index and designing the insurance structure is a multifaceted process requiring diverse skills and know-how.
The first task is creating an objective and accurate index value that is highly correlated to a particular outcome.
For a solar park, for example, we would create a modelled energy production index reflecting the amount of solar radiation the location receives daily. This is then correlated to the park’s historical or projected energy production levels which are, in turn, tightly linked to the operation’s revenues. The index, therefore, acts as a proxy for the revenue shortfalls the client can expect due to low solar radiation.
Arriving at highly correlated index values requires accurate and detailed data and sophisticated analytical capabilities.
We have satellite data going back to the 1980s, so in most cases, we can construct a robust historical record. We also use weather station data from an external partner that certifies a network of top-quality weather stations globally.
And the quantity and quality of the data continue to improve. In fact, an important factor fuelling the increasing interest in parametric solutions, particularly in some emerging market countries, is the growing network of increasingly sophisticated satellites capturing ever more granular data.
We also have an extremely capable team. That’s essential given the technical challenges associated with creating an index as well as the diversity of the risks we insure. All team members have post-graduate degrees in fields like statistics and applied mathematics, climatology and meteorology, engineering and finance; many also have substantial experience in the energy industry and related sectors.
Once we’ve modelled the risk and identified tightly correlated index values, the next step is to design the insurance structure. Since, as noted, each solution is tailored to the client’s particular circumstances and needs, this is an interactive process where we review various trigger level and limit options with the client and its broker.
The critical issue at this point is deciding on the threshold level(s). While lower threshold levels will provide protection for more frequent events, they will also be relatively more expensive. And vice-versa. The final decision, of course, is determined by the client’s strategic objectives, risk appetites and budgets.
Karina Whalley is Marketing and Development Manager at AXA Climate overseeing the public sector portfolio; she also supports AXA’s participation in the 色多多视频 Development Forum. Karina was previously at the African Risk Capacity, a sovereign risk pool providing parametric catastrophe insurance to African governments. She is based in Paris and can be reached at karina.whalley@axa.com
In November 2018, AXA Climate (then Global Parametrics) was awarded “Claims Innovation of the Year” at the European Risk Management Awards sponsored by FERMA and Commercial Risk Europe. It also won the European & UK Captive award for “Most innovative use of an A.R.T. structure”.
