Parametric insurance, an option commonly taken out for perils such as climate change, extreme weather, natural disasters, and travel disruption, is now being proffered as a risk transfer solution for another potential threat: pandemics.
Emerald – through its alliance with Munich Re and its AA-rated security with New Reinsurance Company Limited – last month launched a stand-alone non-damage business interruption solution covering disease outbreaks for the South African corporate sector.
Emerald, an underwriting managing agent within Santam Specialist, says the product is the first business interruption cover for future pandemics in South Africa and the rest of Africa.
Carla Jordan, the chief executive of Emerald Africa, says recent statistics produced by independent data modellers such as Airfinity found there is an approximately 25% to 30% chance of another pandemic of the same or greater magnitude than Covid-19 within the next 10 years.
“That percentage jumps to over 50% within 25 years,” she says.
According to Jordan, after the peak of the Covid-19 pandemic passed, a vast number of global court cases debated whether Covid-19 loss claims constituted a direct physical loss under a commercial insurance policy. She says in most cases, the courts’ rulings went against the insurance industry, “resulting in insurers excluding, from their policies, any cover related to pandemic-induced non-physical damage, to ensure their risk appetite is not curtailed or impaired”.
“This unfortunate but necessary decision has left corporate South Africa without cover against the next pandemic,” Jordan says.
Explaining where the “parametric part” of the policy comes in, Hans Schollenberger, Emerald’s executive head: underwriting and risk, says parametric solutions are popular because they respond to variables, whether it is how much cover an organisation wants or can afford, and their planned strategic response to mitigate risk.
“How much cover to buy is, therefore, of key importance,” Schollenberger says. “In terms of pricing, it may make sense, for example, to have 10% self-retention as a company and buy 90% cover.”
Growing demand for parametric insurance
Aon, a leading global professional services firm providing a range of risk, retirement, and health solutions, has focused its attention on accelerating the delivery of index-based solutions. The firm recently established a global centre of excellence for parametric initiatives and products.
According to Aon’s Global Market Insights Report Q2 2023, demand has continued to grow for innovation around risk transfer, with alternative solutions gaining prevalence amid an “increasingly complex, interconnected and data-enabled risk environment”.
The firm says parametric products have gained momentum, particularly for heavily natural catastrophe-exposed risks.
In Aon’s South Africa 2023 Insurance State of the Market Report, the firm said clients have only benefited via the performance of these solutions, “but parametric insurance improves risk transfer for all parties to the transaction by drawing a crucial distinction between volatility and uncertainty”.
The report states that, in the case of parametric insurance, “the capacity is focused on risks insurers can understand – highly volatile fortuitous events backed by data, such as the frequency of a hurricane at a given location”.
“By contrast, uncertain events where no data exists (for example, the post-event litigation environment) may be more sustainably addressed with other capital solutions. We see this intersection of volatility and uncertainty as a central dynamic impacting risk transfer markets today, where parametric solutions provide the ‘missing link’ to help grow risk transfer and reduce the protection gap,” Aon said.
The protection gap
Thabile Nyaba, the chief risk and sustainability officer at Old Mutual Insure, says the severity of weather-related claims has increased ten-fold in the past decade.
“Floods, wildfires, and severe storms remain the highest-occurring natural perils,” she says.
Daphne Sitole, a senior property underwriter in the facultative business unit at Munich Re South Africa, says the overall losses from major natural catastrophes around the world in 2022 totalled $270 billion.
The difference between economic and insured losses can vary greatly. The KwaZulu-Natal floods in 2022 serve as an example. Described as one of the deadliest and costliest flood events on record in South Africa, the event saw a $3.6bn economic loss and an insured loss of $1.8bn.
The Swiss Re Group, one of the world’s largest reinsurers, puts the protection gap over the past 10 years in South Africa at 67%. Data covering 2013 to 2022 showed that South Africa had suffered economic losses totalling $7bn, while insured losses in this timeframe stood at $2bn.
The missing link
In the face of climate change, parametric insurance has been widely promoted for the role it might play in mitigating and bridging the protection deficit.
Fasken, a leading international business law and litigation firm, identified parametric insurance as one of the major global trends in insurance innovation as far back as 2020.
An article titled “Global Insurance Trends – Parametric Insurance” explains that parametric insurance covers “the probability of a predefined event happening with the pre-agreed pay-out dependent on a scheme or index”.
“Parametric insurance is therefore not attached to the actual loss incurred, as is traditional insurance cover, but rather the happening of an event which falls within a certain index (or timeframe),” the article reads.
Cover magazine (“Parametric to the rescue”) described parametric insurance as a type of insurance where the pay-out is triggered by the occurrence of an event and where the measure of pay-out is calculated according to a pre-agreed approach.
“For example, an earthquake with a magnitude 7.0 on the Richter scale could trigger a pay-out of 50% of the policy’s sum insured, whereas an earthquake with a magnitude 8.0 on the Richter scale could trigger a pay-out of 80% of the policy’s sum insured. Different natural catastrophes require different corresponding triggers to determine the policy response.”
According to Cover, the value of parametric insurance policies, specifically for a market such as South Africa, lies in the fact that an independent trigger drives the pay-out to policyholders, mitigating the need for loss assessments.
“Therefore, products can be offered affordably due to low claims administration costs, and products can also be offered in remote areas, which makes insurance coverage accessible to more people. The policyholders typically also receive much quicker pay-outs than with traditional insurance contracts.”
Challenges of parametric products
Despite the promise this risk solution model holds, parametric products, as with any insurance offering, are not without their challenges.
According to the National Association of Insurance Commissioners (NAIC) in the United States, the most obvious downside to a parametric insurance policy is basis risk. In other words, when the expectation of the policy from the client doesn’t match what they thought they would be paid out.
The NAIC states that the economic losses of the insured could differ by any margin from the amount of coverage, or the insured could have losses without the parameter being triggered.
“Accurately structuring and pricing the product requires a firm understanding of the exact exposures of the policyholder and carefully selecting the most appropriate parameter to fit those exposures.”
Cover, however, says these challenges can be minimised, first, with good data.
“Secondly, ensuring that the trigger used in the product closely tracks the actual loss of policyholders will reduce the basis risk associated with a parametric product.”
Another potential pitfall, Fasken says, is legal and regulatory uncertainty regarding parametric insurance’s operation.
“Some novel product formulations are not governed by statute, and there has been little, if any, common law development in this area to inform how these policies operate, how they are classified for regulatory purposes and how they will be legally enforced.”
The law firm explains that prevailing common law defines an insurance contract as one where, for consideration, an insurer promises to pay an insured if a specified event occurs which has an adverse effect on the interests of the insured.
“There is nothing in this definition to exclude parametric insurance from its operation. However, the common law requirement regarding insurable interest may not necessarily be fulfilled in a parametric policy.”
Another legal impediment is the requirement that the insurance pay-out must correspond to the actual loss suffered and may not exceed that loss.
“Failure to establish these requirements will in many instances lead to parametric insurance products being treated as derivative investments and therefore will be regulated as such.”
The law firm states that requirements for parametric insurance products operating in South Africa stipulate that the insured must prove that a loss was in fact suffered and that they have an insurable interest in the loss.
