March 17th, 2015

Parametric CAT Derivatives to “Build Back Better”

Posted at 1:00 AM ET

franco_guillermo_bioGuillermo Franco, Head of Catastrophe Risk Research - EMEA


Destruction caused by catastrophes often unfolds due to inadequate construction practices or land use planning. The likely response to these events is to strive to “build back better,” in part by addressing the mistakes of the past. Unfortunately, communities that embrace this challenge often find that they lack the financial resources for it and ambitious reconstruction projects lose momentum.

Insurance can be a powerful contributor to financial resilience by providing needed monetary resources to rebuild. But the spirit behind the fundamental concept of indemnity, which underlies all traditional insurance solutions, is to restore the insured to the conditions that existed prior to the loss. And thus, rather than helping communities “build back better,” insurance is really geared to help them “build back the same.”

Treasured for their transparency and fast response, parametric derivatives have been used as a channel for the convergence market to deploy capital in the reinsurance space. Their usage to date has only been limited by their basis risk, the lack of perfect correlation between actual losses and the physical event parameters used to determine the contract payments.

The expected losses of the parametric derivative, not of the underlying assets, determine the price of the transaction and thus investors are not particularly concerned with basis risk. But basis risk is important for sponsors and cedents since large events that cause damage but do not trigger payments produce a situation of underinsurance. However, if contract payments are less directly connected to specific physical assets, cedents can be tolerant or even supportive of basis risk that acts in their favor. Indeed, the lack of perfect correlation with actual or modeled losses is being increasingly perceived as a resource to account for hard-to-quantify losses such as business interruption or demand surge.

Communities exposed to natural hazards are nowadays encouraged to develop recovery plans - documents that can guide them in a post-disaster situation when decisions need to be made fast. Measures taken to improve the immediate well-being of the population can be in direct opposition to sustainable long-term resilience and these plans help to frame these issues in a time of pre-disaster comfort.  Parametric derivatives can be a natural complement to these plans by providing the rapid influx of cash necessary to bring well-thought recovery plans to execution when disaster strikes.

Insurance plays an obviously important role in catastrophe risk transfer but the solutions offered by the industry may not address all existing needs. Indeed, as we know, 70 percent of catastrophic losses in developing and developed countries remain uninsured. Possibly, the indemnity concept needs to be recast and modernized. Parametric derivatives, in the form of adequate and affordable products for risk-prone communities, may be the answer for our industry to assisting stricken countries to actually engage in “building back better.”

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