Data and analytics advances may help parametric cat bond sponsors on basis risk: AM Best

Sponsors of catastrophe bonds with parametric triggers may benefit from advances in data and analytics that can help them in gaining a better understanding of the basis risk inherent in these instruments, analysis from AM Best suggests.

In its latest report on the insurance-linked securities (ILS) market, rating agency AM Best has highlighted the continued use of parametric triggers in catastrophe bonds, especially for government sponsors.

“Record cat bond issuance volume and persistently large cat bond spreads demonstrate that demand for reinsurance capacity remains high. To satisfy that demand, reinsurance and ILS covers with parametric triggers continued to see interest from cedents and capacity providers in the first half of 2024,” AM Best explained.

Adding, “Sponsors issued six natural catastrophe bond tranches with parametric triggers in first-half 2024, accounting for approximately 7% of volume during the period, just above the 6.2% issuance volume during first-half 2023. Once again, government sponsors are sourcing parametric reinsurance from the cat bond market.”

In addition, AM Best highlighted the first parametric cyber catastrophe bond,the Cumulus Re (Series 2024-1) transaction that provides reinsurance firm Hannover Re with cover against cloud outage risks.

“The Cumulus Re transaction serves as evidence of the interest in deploying the concepts and techniques of parametric risk transfer, originally rooted in meteorological and seismic phenomena, to other types of risk,” AM Best said.

The rating agency also highlighted regulatory moves that are expected to help drive more interest in parametric risk transfer, such as Vermont’s update to its protected cell law to allow for use of different parametric structures.

In recent months there have also been regulatory moves in Latin America to support greater use of parametric insurance in the region.

“The transparency of these triggers makes them appealing to capacity providers as well as cedents. The lower uncertainty of the triggers may motivate capacity providers to expand coverage to other perils and other geographies, allowing investors to benefit from potentially greater diversification in their ILS portfolios,” AM Best continued.

But that has not come without its challenges for sponsors, as there remains a lack of education around how parametric coverage can work alongside traditional forms of indemnity based protection, or other financing sources.

Case in point, the fact Jamaica’s parametric cat bond did not trigger after hurricane Beryl has now hit mainstream headlines, as well as other news sources.

The coverage fails to recognise how Jamaica has built out a layered approach to disaster risk transfer and financing, which seems important information to consider when discussing what instruments did respond, or not, and most importantly why.

That country’s Minister of Finance Dr. Nigel Clarke went to some lengths to explain why certain instruments paid out after Beryl, while others didn’t, saying the program was designed in the knowledge that not every instrument is expected to be activated after every storm.

Jamaica’s cat bond sits in the top, most remote, layer of its program of disaster risk financing instruments, which you can see more details on here.

There have been calls for parametric cat bond triggers to be redesigned to ensure countries get a payout whenever severe conditions hit them.

It would certainly have been possible for Jamaica’s cat bond to be structured in such a way that it would have responded to hurricane Beryl. But, for every adjustment to the trigger structure to support payouts for less severe or intense events, the costs of coverage would have increased and somewhere a line must be drawn between affordability and payout-potential.

It’s also important to note, which other media coverage has mostly failed to do, that Jamaica’s $150 million cat bond coverage now remains fully in-force through to the end of the 2027 hurricane season (so the rest of this season and three more), to provide its protection should any other major storms strike the island that do breach the trigger parameters. That’s a fact often lost in the discussion.

All that said, it is entirely understandable that when a cat bond trigger experiences such a near-miss as Jamaica’s did with Beryl, that questions get asked.

AM Best explains in its report that “reinsurance covers based on parametric triggers complement indemnity-based covers, rather than directly substitute for them,” another fact that often gets lost in the eventual discussion about these instruments.

The rating agency continued, “They can be used by insurers to plug holes in reinsurance towers for earnings protection, particularly in the harder-to-place lower layers. Or they may be used when indemnity coverage is simply not practical, as in the case of the parametric cat bonds reinsuring governments.

“Sponsors that use parametric coverage must be comfortable with basis risk and the potential for over- and under-recoveries.

“However, advances in data and analytics may help sponsors better understand the extent to which a parametric trigger correlates with the magnitude of loss they might incur during an event.”

That is something we have been saying in our tracking of the use of parametric triggers in the catastrophe bond market for over two decades.

Triggers have been improving, helped by advances in both the models available and the data used, as well as continued advancements in structuring techniques. But still there is a need for continued education, not just about how triggers work but also about the reasons for using parametric triggers, how they work alongside other financing sources, the risk they don’t payout and the potential for gaps between economic impacts and those payouts.

AM Best’s assessment, that enhancements to the available sets of data and the risk models used can assist in educating on the basis risk inherent in the coverage, resonates with findings from our sister publication Reinsurance News in a recent poll.

Reinsurance News asked what is holding back greater use of parametric insurance and risk transfer and the top answers to the poll were a lack of data and models, followed by a lack of education on the structures.

It’s not so much understanding what parametric triggers can do for a cat bond sponsor, or risk transfer buyer. It’s more understanding how the structure fits within its overall program and financial protection, when it should anticipate a payout and importantly what it can do to layer other instruments around the parametric solution to provide much-needed payouts when an event is not severe enough, or misses the specific trigger parameters.

That is something Jamaica has spent significant time and resources on understanding, resulting in its sophisticated multi-layered and multi-instrument based approach to its disaster risk financing program.

As we said, there is also a necessary trade-off between affordability and the cost of the protection as well. Structures must clearly define the parameters required for payouts to occur, so that risk metrics of the transaction can be defined and thus pricing be derived.

How that line is drawn, between the cost, efficacy of coverage and the potential for a payout to occur, is undoubtedly something that the industry can and will continue to work to improve, while more advanced structuring techniques, improved data availability, entirely new data sources, and model enhancements, are all going to assist greatly in this regard.

Because of the very nature of a parametric trigger though, in requiring certain pre-defined event parameters to be breached for a payout of coverage to come due, there is always going to be a risk of near misses, no matter how the structure is designed.

Many parametric insurance companies now offer blended products, including an element of indemnity within the trigger, so a proof of loss. But that is generally a way to help in dovetailing parametric coverage with traditional, while also keeping costs more affordable by reducing basis risk on the carrier side.

In the past we’ve discussed the potential to construct hybrid parametric triggers that also feature an economic loss trigger for sovereign or government sponsors, but that requires a third-party reporting agent for the economic portion, as without one many would say an element of moral hazard could be introduced.

With parametric risk transfer techniques advancing all the time and prevalence of parametric risk transfer increasing across the insurance and reinsurance market, it is to be expected that innovation will help to drive forwards the design of these triggers and structures.

Ultimately, this will serve to both make them more understandable for the sponsors, those seeking protection, and for investors or capacity providers. While also allowing the trigger itself to be more tightly calibrated to both the exposure being protected and importantly the use-case (or payout cases) envisaged for them.

You can view details of catastrophe bonds featuring parametric triggers in the extensive Artemis Deal Directory, by filtering the list of transactions by trigger type.

You can also track the use of parametric triggers over time in the cat bond market using one of our charts.