AXA XL examines the benefits of Parametric insurance
Authored by Head of AXA Climate for the Asia-Pacific region Ankush Bhardwaj
Public and private sector clients around the world, including many in the Asia-Pacific region, increasingly recognise the benefits of parametric insurance for mitigating various weather-related risks.
These benefits include certainty, speed and cost-efficiency. Certainty because the coverages are automatically triggered when data from objective, third-party sources fall outside pre-agreed thresholds. In other words, clients know how much they will receive once certain conditions are met. And since a lengthy loss adjustment process isn’t needed, they can expect the payout to be made in days or, at most, weeks. That also helps to keep costs down as claims managers, attorneys and other technical specialists aren’t needed to assess the losses. Moreover, potentially fraudulent claims are not an issue with these policies as the insurance programme relies solely on independent data sources.
Three basic elements
So, how are these benefits achieved? Parametric or index-based insurance has three essential elements.
First is the risk(s) to be covered. As with indemnity insurance, parametric solutions are designed to mitigate external circumstances outside an organisation’s control that have a significant bearing on revenues or costs, e.g., too much/not enough rainfall or wind, prolonged heat or frost, or extreme seismic events. Some rain, for instance, is a blessing for farmers. Torrential rains, on the other hand, could destroy a crop. Similarly, an energy utility operating hydroelectric plants could benefit from heavy rains. Long dry spells, however, could lead it to default on contracts with a municipality.
Next is the threshold level or index value (the terms often are used interchangeably). That is the point where those external circumstances start to cause harm in terms of lost revenue, increased costs or both. The threshold level is informed by models—based on historical data—showing the economic consequences that follow from different types of events. A model for a vineyard, for example, would incorporate data from various sources—e.g., local monitoring stations, weather satellites—to illustrate the impact of hard freezes on revenues and expenses. For instance, if the mercury falls below a certain temperature for a pre-defined period, the vineyard owner would be compensated by a pre-agreed amount reflecting their reduced revenues (from harvesting fewer grapes or producing lesser quality wine) and/or increased costs (from running expensive heaters).
Last is the limit; the maximum payout that will be made. Here it is important to note that for it to qualify as insurance, the limit must be less than or equal to the client’s actual losses.
Also, the threshold level can be either binary or tiered. With the former, the full limit is paid when a value above or below a pre-defined threshold is recorded. Alternatively, a tiered or linear structure can be used where the payout is linked to the severity or magnitude of an event; a Category 4 cyclone within a pre-defined radius, for instance, would trigger 80 percent of the limit while a Category 5 one pays 100 percent
Finally, parametric policies are always tailor-made. Each of the elements—the risks, index value and limits—is defined by the client considering its strategic objectives, risk appetites and budgets. Furthermore, the policy can cover specific locations/facilities, or, as is common with government-backed programmes, operations in entire regions/districts.
Increasing interest across the region
Governments in India and China were some of the first to use parametric coverages to protect their agricultural sectors. India, for example, uses parametric data from local weather stations to insure 35 crops in 17 states.
Companies across the Asia-Pacific region also are starting to recognise the benefits of parametric solutions for mitigating certain risks. I believe that three factors are prompting this increased interest:
1. An evolving traditional insurance market featuring less capacity, higher rates and narrower coverages. (My colleague, Zoe Xie, Client and Distribution Leader, Asia, wrote about this in late 2019. Her article is featured here.)
2. Increased exposure to more frequent and severe natural catastrophes, especially cyclones and erratic rainfall levels, as a result of global warming.
3. More robust parametric solutions. Today, there is more and better data as well as greater expertise in modelling the correlation between different events and a client’s revenues and/or costs. Also, as re/insurers like AXA XL write more parametric coverages, clients benefit from the greater stability/lesser volatility associated with increasingly diversified portfolios.
Following are some examples describing the relevance of parametric solutions in different industry sectors important in countries across the region.
The agricultural sector is a vital element in countries across the region, both in ensuring local/national food security and as a source of income. In Vietnam, for instance, agriculture accounts for 15.3 percent of the country’s GDP. In Indonesia, it’s 13.9 percent.
But farming is a tough business. Considering the multitude of risks farmers must contend with, there is always the possibility that their harvests will fall short of expectations if not fail completely. And weather perils like drought, excessive precipitation, hail, wind and frost top the list.
Although, as noted, governments in several countries have endorsed parametric programmes to protect farmers across entire districts, private companies also are using these schemes to lessen volatility as extreme climate events become more common. For example, AXA XL recently developed parametric programmes for a couple of major Australian grain exporters that source various crops from different parts of the country. Based on average yields for individual crops in specific regions, we created models that show how, for instance, different levels of cumulative rainfall will impact harvests and led to revenue losses.
Many Asia-Pacific countries have ambitious plans to dramatically increase energy production from renewable sources like solar, wind and hydropower. Note that four of the world’s largest solar power plants are in China and two are in India. And that Vietnam could be producing around 10-12 gigawatts from offshore wind by 2030. (My colleague MeiYean Lim, Senior Underwriter, Political Risk- Credit & Bond, recently wrote about how Asia is poised to become a leader in offshore wind energy. Her article is here.)
But sometimes the sun doesn’t shine, or the winds don’t blow. Or the rivers run dry; that was the case last year in the Philippines. A prolonged drought there related to an El Niño phenomenon resulted not only in sharply curtailed production from large, small and micro hydroelectric plants, but also led to severe water shortages; the damages to the nation’s important rice and corn corps also were severe.
Travel and tourism are economically more significant than agriculture in many parts of the region. For instance, take Thailand. There, this sector accounts for a whopping 19.7 percent of the country’s GDP and 21.4 percent of total employment. At the same time, the country’s hotels, resorts and tourist attractions are exposed to increasingly severe cyclones
And when a cyclone is announced, reservations are cancelled virtually instantly. Moreover, even if the cyclone changes course and the property isn’t affected, those bookings don’t return; the rooms remain vacant. (Resort operators in Indonesia report having similar experiences.) Likewise, airports have to shut down operations if a cyclone is announced within close proximity; that has clear economic ramifications on top of any physical damages the storm may cause, if any. Also note that any non-damage business interruption losses that occur will not be covered by most traditional insurance structures.
In all of the examples noted above, parametric insurance could provide effective and cost-efficient protection against these varied risks. And in addition to these three sectors—agriculture, renewable energy and hospitality—parametric coverages also are highly relevant in many other industries including:
• Construction: For projects where excessive heat, cold or wind causes delays and/or increases costs.
• Transportation: For shipping companies facing reduced revenues when river levels are abnormally high or low, or airlines with increased de-icing expenses.
• Automotive: For manufacturers, shippers and dealers with vehicles parked in locations prone to hailstorms.
In summary, parametric insurance represents a simple yet elegant solution that helps clients mitigate diverse climate-related risks. And since the payouts are certain and delivered promptly, parametric coverages can significantly boost a company’s ability to quickly respond to and rebound from a damaging event, i.e., become more resilient, something that’s increasingly essential in today’s turbulent times.
AXA XL, the new division of AXA Group, combines XL Group operations, AXA Corporate Solutions and AXA Art, to provide property, casualty and specialty risk insurance and risk management products and services for mid-sized companies through to multinationals, and reinsurance solutions to insurance companies globally. We partner with those who move the world forward.
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