DAMAGE CONTROL: Parametric Insurance: An Emerging Tool for Financial Risk Management.

• Author: Kavanagh, Shayne C.
• Position: COVID-19 SPECIAL SECTION: FISCAL FIRST AID

Local governments have a duty to respond quickly and decisively to extreme events and provide continuity in critical public service through adverse circumstances. Reserves or "rainy day funds," federal assistance, and indemnity-based insurance (1) programs are the primary tools governments have used to manage risk associated with events, such as natural disasters, recessions, etc., that have the potential to disrupt public services.

In recent years, a type of insurance instrument called "parametric insurance" has generated interest in local governments in North America to help fulfill risk management needs that aren't met by indemnity-based insurance, federal assistance, or rainy day funds. Parametric insurance is not new--it has been around for over 20 years. It has been used to protect Caribbean nations against natural disasters and insure energy companies against disruption to their revenue stream due to unusually cold summers or warm winters, for example. For state and local governments, parametric insurance can provide resources to cover damages not covered by federal assistance or indemnity insurance or that go beyond what a government's reserves can cover.

The idea behind parametric is quite simple. Exhibit 1 illustrates the process for payout from a parametric policy and compares it to that for traditional indemnity insurance. Let's walk through the essential steps shown in the exhibit.

As a first step in a parametric policy, for any given risk event that the insured wishes to protect against, an objective measure of that event's impact is established. To illustrate, local wind speed could represent a hurricane's financial impact, and local ground-shaking intensity could represent an earthquake's financial impact. The insured receives a payout of predetermined size if a threshold intensity of the event in question is met or exceeded. To illustrate an example with hurricanes, a payout of $5 million might be triggered if wind speeds in the insured's location exceed 80 miles per hour.

The size of the payout is not directly calibrated to actual losses the insured experiences from the event, as it is with a traditional indemnity policy. The limit of the parametric policy is determined by past experience, exposure to risk, and anticipated resources needed to assist recovery after an event. The sizes of the payouts are also predetermined and are based on the intensity of the event the insured experiences. Also, the insured is not required to use the money to mitigate any particular loss or type of loss. For example, the insured may be required to use the payment from a traditional property insurance policy to repair the property that is the subject of the policy. A parametric policy can be used to offset any expense the insured experiences arising from the insured event.

The initial payout is not directly calibrated to an actual loss; it is determined based on the event intensity alone [e.g., the local wind speed of a hurricane]. Therefore, parametric does not require the in-depth process to assess damages, submit a claim, and wait for insurance adjusters to do their work, as is found with traditional indemnity policies. Instead, the client alleges that the threshold intensity of the event has been met or exceeded. The allegation is verified by a third party that is mutually agreed upon ahead of time [it is not verified by the insurer]. Thus, the time between the catastrophic event and the payout will typically be much shorter than with indemnity insurance. This is because third-party verification on the intensity of the event can happen almost immediately. Parametric is also free of the debate with adjusters that sometimes accompanies indemnity insurance. Finally, in Exhibit 1, you will note that the end of the parametric process requires confirmation that the insured experienced a loss equal to or greater than the amount of the payout that was received. (2) The form this loss takes is flexible. It does not have to be tied to damage to specific property and could cover costs as diverse as overtime for public safety personnel and lost tax revenue from the closure of local merchants.

In this article, we will review the most import things local governments need to know about parametric insurance, including:

* Why local governments might wish to consider parametric insurance.

* Who is using parametric insurance, including a review of the experiences with parametric of two US local governments and one state government.

* How to explore the use of a parametric policy.

* A review of the advantages and disadvantages of parametric insurance.

Why Parametric Insurance Now?

It is important for local governments to consider new risk management tools, like parametric insurance, because the number of disasters has been increasing over time, as Exhibit 2* on the next page shows. The rate of increase has been much faster than the rate of population growth. Additionally, research shows that there is also a trend of significantly increasing aggregate financial losses from disasters. (3)

Parametric insurance can supplement local governments' traditional means of risk management: federal [and state/ provincial] assistance, indemnity insurance, and reserves.

Let's start with federal assistance [e.g., the US Federal Emergency Management Agency or FEMA], Federal assistance will not cover all of the losses a local government experiences. First, the federal government must declare that an event qualifies for assistance.

A local government could still experience significant losses from an event that is not declared eligible for assistance. Second, even for qualifying events, assistance recipients are still responsible for a significant share of the reimbursable costs [e.g., typically, FEMA requires 25% of the cost be borne by the recipient], and other costs may not be reimbursable. A leading example of a non-reimbursable cost is lost revenue if part of the tax base suffers damage and is no longer able to contribute the same revenue to local government. Finally, federal assistance may take a long time to materialize--perhaps years in some cases. Parametric policies can help cover losses that aren't covered by federal assistance and can deliver the payout quickly. Some local governments might also be eligible for similar assistance from their state or provincial government. However, the limitations of federal insurance often apply to state/ provincial assistance too.

Traditional indemnity insurance policies provide coverage for a government's physical assets and provide protection in many different loss scenarios. Because these policies provide protection against losses arising from so many causes, a policy that provides a high dollar amount of coverage can be very expensive. This limits the amount of coverage a government can obtain and/or it requires significant deductible payments to make the policy affordable. A parametric policy could supplement a traditional indemnity policy by focusing on the specific loss scenario [i.e., earthquakes, hurricanes] that is most likely to cause extreme damage. Thus, the parametric policy could help cover deductible costs and/or damages in excess of the traditional indemnity policy's coverage limits, or items that are sublimited (4) or excluded under the indemnity policy.

Further, indemnity policies don't cover losses outside of damage to physical assets. For example, an indemnity policy wouldn't cover overtime costs for public safety personnel. A "business interruption" indemnity policy could cover lost revenue from damage to the insured physical asset; it would not help if an extreme event left the facility undamaged but disrupted the underlying economic activity that produces revenue. For example, a business interruption policy for a marine port would only help if the actual port facility was damaged. If an extreme event limited ingress/egress to the port without damaging the physical facility, then a traditional indemnity-based business interruption policy would not apply. A parametric policy could be designed to provide a payout regardless of the physical condition of the gate. (5)

Reserves traditionally have acted as a form of self-insurance for local governments. However, many local governments will find it impractical to accumulate enough reserves to cover the most extreme scenarios or could find their reserves exhausted by multiple smaller events. This could be because the local government is unable to generate sufficient excess resources to build the reserve to an adequate level quickly enough.

Or perhaps a large reserve will attract political pressure to use the reserves for something other than risk management. Parametric insurance can act as a safety net if a government's reserves prove insufficient, and it may be more resistant to political pressure to spend the premium money on something else.

A final reason why local governments should think about the potential of parametric insurance is that the insurance market is starting to favor it, which means it could provide a better value to the insured than traditional indemnity insurance, in some cases. As of this writing, at least some of the value advantage of parametric is due to cyclical market forces that could prove temporary. However, there are some forces that suggest parametric could now have a natural value advantage. First, as we saw earlier, parametric policies don't have a claim administration and adjustment process. This process represents a cost of indemnity insurance that is passed along to customers. Second, the increased prevalence and accessibility of data and data collection devices make parametric policies more practical to design and administer than they have everbeen. For example, for a parametric...