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Could the basis risk 'bogeyman' threaten the rise of parametric insurance?

Basis risk need not be the enemy of parametric insurance products, according to specialists, despite concerns that it could undermine trust in the coverage.

Unlike traditional indemnity insurance, where payment is dependent on the loss incurred by the policyholder, parametric covers pay out when measurable elements of a catastrophe, such as wind speeds, exceed a pre-determined threshold. Index insurance uses statistical loss indices, rather than actual losses, as the payment trigger.

Parametric and index insurance are seen as key tools in the efforts to close the protection gap — the difference between economic and insured losses — for natural catastrophes. While such products are unsuitable for covering individual policyholders, they are being employed at company, regional and country level.

Their main strength is that a known amount of money can flow quickly to where it is needed after a disaster, or in some cases before a catastrophe has fully played out, as there is no need for complex and time-consuming loss assessments. But their Achilles heel is basis risk the likelihood that the payments do not match the incurred losses. If the weather station used to measure the wind speed for a parametric trigger is remote from the property being covered, for example, the insured could suffer heavy losses yet receive no payment.

Undermining trust

Basis risk exists in standard indemnity insurance policies, but is more pronounced in parametric and index-linked products because of the more distant relationship between loss and payment. It was brought to the fore after an Ebola outbreak in the Democratic Republic of Congo, which began in 2018, failed to trigger the World Bank's pandemic bond, launched in 2017 as part of the $500 million Pandemic Emergency Financing Facility for emerging markets.

The bond part of the package is triggered when an outbreak reaches certain thresholds, including number of deaths, speed of spreading, and the crossing of international borders. It has a cash facility for nonqualifying events, which has paid out $50 million so far, but a lack of payout on the insurance portion has sparked a wave of negative press.

When products do not pay out as might have been expected, it can undermine trust. Daniel Clarke, director of the U.K. government's Centre for Disaster Protection, said in an interview that it is was important for all parties to understand the cover and why it is the right solution.

"Disasters can be very highly charged political environments and we've seen examples, particularly where insurance products have been sold to farmers, where all you need is one basis risk event and the entire market just falls apart," he said.

A study published in July 2018 of the Kilimo Salama weather index insurance program, which covers Kenyan farmers for drought and excess rain, found that the lack of a payout in 2013, when many lost crops due to low rainfall, "may have contributed to lower insurance uptake in 2014."

Clarke said that while there were "good reasons" for the "remarkable growth" in parametric and index insurance products, there are questions in some cases about whether buyers truly understand what they are getting, and there can be "big ramifications" if those buyers are governments.

"It is not good for anyone if people are buying the wrong product, but it's also not good for the insurance issuer in terms of their trust and their brand," he said, adding that solving the problem "is mainly a communication issue as well as partly a design issue."

However, experts also warn that while basis risk should not be ignored, it should not be overplayed either.

"There's a sense in which people think that basis risk is the bogeyman, or, [if] you say 'parametric', they hold up basis risk like it's a crucifix," said Daniel Stander, global managing director at risk modeling company RMS. But the reality, he added in an interview, "is that there is always basis risk. Even in an indemnity contract there is basis risk."

Parametric covers are "far and away the easiest way to transfer risk into the market," Stander said, and this is "increasingly going to be the case."

Clarke also noted the positive case for parametric covers, in spite of the "big downside" of basis risk.

"If you list all of the advantages and disadvantages [of parametric covers], nearly all of your list is going to be on the advantages side," he said.

Making it pay

There is also an argument that the potential mismatch between loss and payment can be a strength, not just a weakness, of parametric and index products, as it allows coverage that more tailored policies would preclude.

"Previously uninsurable risks based on the bespoke needs of the customer are often insurable with parametric triggers," said Ernst Rauch, chief climate and geo scientist at Munich Re, via email.

In addition to speedy and certain payments, parametric payment triggers can be far simpler to understand than the mechanisms of a traditional indemnity insurance contract. This means that capital markets investors, as well as buyers, can get to grips with parametric products, opening the door to financial backing from beyond the traditional insurance and reinsurance industries.

Technology and risk modeling continue to advance, bringing the promise of more intricate parametric structures and less basis risk, noted Wynne Lawrence, senior associate at law firm Clyde & Co.

"We have the data processing capabilities to be able to create and design quite complex triggers and to be able to model in advance what losses might be when those parametric triggers are satisfied," Lawrence said in an interview. Developments such as the greater proliferation of weather stations, the ability to capture weather data from space and the use of artificial intelligence for rapid data analysis "will enable us to have a very real-time understanding of risk factors," she added.

Parametric cover may not be a perfect solution, but it is likely to continue to play a key role in helping governments and insurers provide cover to those without it. Stander said: "We think parametric will continue to lead the way with most product innovation, especially when we are thinking about closing the protection gap in developed and developing markets."