Using Parametric Insurance to Match Capital to Climate Risk

Climate change is enhancing the frequency and severity of natural catastrophes across the world. Global natural disasters in 2022 resulted in economic losses of $313 billion, and only $132 billion of that was covered by insurance. It was the fifth costliest year on record.^[1]

The increase in natural catastrophe activity has made it essential for risk managers and business leaders to make better decisions to navigate these events.

Traditional insurance markets offer solutions, but they are largely focused on physical damage impacts, while the economic exposure faced by clients is much broader. That includes loss of employee income and the impact that has on the local economy, and more. Furthermore, these solutions are not designed to provide strategic access to liquidity, which is especially needed at a time of crisis.

Cat-Prone Businesses are Taking an ‘If-Then’ Approach with Parametric Solutions

Risk managers are rethinking their risk resilience by turning to parametric insurance, an “if-then” model designed to complement and supplement a traditional indemnity program and better match capital to the broad nature of risk from natural disasters. Parametric insurance is an innovative, transformative and straight-forward solution, well suited for “grey swan” catastrophic events such as earthquakes, named windstorms, hailstorms, tornadoes and wildfires, among other perils.

Parametric insurance can dovetail traditional insurance solutions and lower the total cost of risk by allowing an organization to proactively increase its program retention and fund a portion of a parametric solution with the associated premium savings. By integrating the parametric solution, businesses free up capital by carrying less non-traditional risk.

Parametric insurance’s core mechanics can be defined by three key attributes:

The “if:”Parametric is differentiated by its coverage trigger and pre-agreed payouts. Underwriting is simplified as coverage is triggered by the occurrence of an independent event as determined by neutral third-party data providers.

The “then:”With the independent data trigger and pre-agreed amounts, recoveries occur quickly — often as soon as 10 days after an event. This is critical for businesses that need quick access to capital following an event.

Solving the protection gap: Coverage is broad. Any economic exposure arising out of an event can be insured. As a result, uninsurable exposures become insurable, and the parametric trigger provides the “missing link” to unlock contingent capital.

Parametric solutions can also be well-suited for other exogenous events. Capacity providers can underwrite parametric policies that address exposures related to a drop in tourism volume, pandemics, cloud service outages, and other situations where there is an impact from an event that can be described by independent data.

A Complement to a Traditional Risk Solution Program

How Aon Has Implemented Effective Parametric Coverages Across Industries and Regions

1. Deploying Parametric Capacity as a Hurricane Risk Supplement in North America

An energy services firm on the gulf coast of the United States (U.S.) was concerned about the potential impact of a catastrophic hurricane to its facilities, especially following a prior adverse experience from Hurricane Laura in 2020. The firm is currently retaining a substantial property risk with a $10 million deductible. Its existing insurance covers property damage only, with no coverage for business interruption and additional expense.

Solution:

The client’s traditional insurance program was augmented with a $50 million limit parametric solution triggered by a named storm track coming within 20 to 40 miles of the facility, as determined by the National Hurricane Center.
Coverage attaches at a category 3 strength storm and increases in stepwise fashion as the storm proximity narrows and/or intensity increases.
The parametric solution covers any economic loss arising out of the triggering event.

Evaluating the Outcome:

Parametric solutions provide a unique opportunity to assess exactly how a policy would perform if prior events were to reoccur. In this case, prior losses from Hurricane Laura yielded an uninsured exposure of $36 million. The parametric solution would have triggered a $37.5 million payout for Hurricane Laura had it been in place at the time. The claim would be settled within a month of the event, providing liquidity at the time of the crisis, rather than self-retaining or navigating a prolonged traditional claims process.

This type of “backcasting” analysis allows us to ensure that parametric triggers are calibrated to potential economic exposures based on prior events.

2. Using Parametric to Help Maximize Resiliency to Earthquake Risk

A U.S. company’s corporate campus is in an earthquake-prone area and exposes the client to a mix of controllable factors (engineering and construction of owned physical assets) and uncontrollable factors (resilience of employees, customers, and other community stakeholders impacted by potential loss).

The company was especially concerned about the long period without earthquakes the area was experiencing, which created questions about collective resiliency and preparedness for a potential event.
Internal analysis pointed to significant concern with the resilience of local public utilities and services on which the company and its employees depend.
Other concerns faced included challenges with traditional insurance, including inherent coverage limitations, timing mismatch of claim payments vs. when problem is being managed, and a hard insurance market forcing large risk retentions.

Solution:

In the design of the solution, the key challenge is to correlate the response to the exposure by defining key geographical areas of concern. Trigger locations associated with these areas are then set and become the building blocks for the parametric solution.
Once measurement points are established, limits are distributed among each of the points in proportion to the level of exposure. For each trigger location a pre-agreed payout matrix is created based on the intensity of exposure. The intensity of an earthquake will drive the payout level, and is based on metrics provided by the U.S. Geographical Survey (USGS), an independent third party.

Evaluating the Outcome:

The solution can be tested based on past events or hypothetical modeled earthquake scenarios to assess the value and mechanics of the coverage. With this solution in place, the client maximizes its holistic capital response to its earthquake exposure, maximizing “dry powder” and assuring its ability to navigate through volatility.

3. Addressing Severe Weather Risk with Parametric Solution in Asia

A leading renewable energy provider in the Philippines, with a vast network of physical infrastructure and distribution networks across the country, was concerned about the potential impact of a catastrophic weather event to its facilities. The Philippines averages 20 storms and typhoons annually, causing millions in losses and disrupting vital public utilities like electricity services.

The local insurance market in the Philippines provides very limited coverage via traditional property damage products for the energy transition and distribution industry, with limited capacity and many exclusions. To address this, Aon needed to deliver a program to transfer key physical damage and business interruption exposures.

The business required a solution that would effectively price its risk exposure and simplify what had historically been a difficult and complex damage and insurance claims assessment process.

Solution:

We modelled past catastrophic weather events over a two-year period, with a particular focus on windstorm/tsunami risk impact.
A bespoke “pole and wire” windstorm model was developed to quantify the infrastructure and property loss at different pre-agreed levels of maximum sustained wind values on a 1 to 5 category scale based on historical pricing. This allowed us to develop an appropriate cost for potential damages to the network.
The captive obtained terms for a parametric solution covering windstorm risk, with claim payments designed to match storm proximity and severity.

Evaluating the Outcome:

The solution enabled the energy company to make quicker and more straightforward claims. In December 2021 the program was triggered following Typhoon Rai with a payment made within 30 days (and within 10 days of the program being finalized).

The most important and significant aspect of the solution has been the elimination of the difficult, time-consuming and complicated damage assessment work that would have been required to make a claim on a traditional insurance program.