Parametrics: Don’t blame it on the basis risk

Some 27 years since I had my introduction to parametric triggers, one factor is still cited as holding back broader adoption, the issue of basis risk.

But there are now signals that suggest the industry is finally beginning to overcome this perceived coverage gap and has reached a stage in its maturity where perhaps basis risk won’t get the blame anymore, at least not every time.

Basis risk, the gap between coverage limits and actual payouts, or payout quantum and damage suffered. It’s an issue parametric insurance and risk transfer has faced since its infancy.

It’s hard for buyers to get over this issue, which under their typical approach to buying protection can look like a gap in coverage and so a risk or uncertainty they are not keen to assume.

Near-misses haven’t helped.

There have been near-misses, where parametric risk transfer structures failed to payout but the protection buyer felt they should have, going right back to the beginning of the market in modern parametric risk transfer (say mid-90’s).

Unfortunately many media sources, mainstream and B2B, often jump on these as headline opportunities without ever looking deeper to see how the protection buyer felt about that miss.

Often a basis risk miss is not seen as failure at all, just as one part of a holistic risk management strategy that wasn’t activated by that particular event.

I digress. Basis risk remains a key consideration for discussions of parametric risk transfer market growth.Of course, basis risk is also evident in indemnity insurance and reinsurance structures as well.

But, in many cases, it’s not the basis itself. It’s the lack of education about the risk, or even a lack of innovation in attempting to manage and minimise it, that really exacerbates the issue.

The insurance and reinsurance industry has a habit of sticking to what it knows best. Which means parametric triggers can be structured without thought as to how they are best integrated into programs and towers.

But this is changing, thanks to the growing wave of interest in parametric risk transfer and the growing number of innovative specialists in the space.

We now have truly innovative underwriting companies looking to push the parametric needle, while brokers are increasingly sophisticated in their parametric and holistic risk management offerings as well.

When it comes to basis risk in parametric risk transfer arrangements, things are moving on (finally).

While basis risk is never going away, it’s no longer something to be feared (or at least it shouldn’t be).

Think back to almost 30 years ago when the first of the parametric risk transfer structures that are similar to those we see today emerged.

They were simple and simplicity was encouraged at the time, in parametric trigger design.

The level of technological advancement in the insurance and reinsurance industry was relatively low back then.

The first parametric catastrophe bonds in the mid to late 90’s saw concentric rings and boxes drawn around locations, with different parameters used for different levels of severity responsiveness by triggers.

Sound familiar? Yes it was simple, but it’s not all that different to today and simplicity and transparency are still key for many parametric programs.

What has changed is how advanced the technologies underpinning risk models and analytics have become, as too have the structuring techniques, while the accuracy, reliability and range of data sources for trigger inputs is now expansive.

Which means parametric triggers can be designed to more tightly integrate with a protection buyers’ existing insurance or reinsurance program and tower arrangements, making for reduced basis risk.

But we believe the market can go further and we’re starting to see some parametric specialist companies taking basis risk reduction to another level.

We’ve seen brokers working with specialist underwriters to undertake a ground-up re-analysis of portfolio exposure and a reassessment of how risk is transferred, or reinsurance bought, for their clients.

This can drive insights that assist in dovetailing parametric risk transfer more neatly, closely matched and tightly integrated alongside traditional sources and types of coverage.

We’ve seen multiple reporting sources used, the hybridisation of indemnity+parametric structures, use of sensors, algorithms to derive indices, secondary data sources, and all important innovation around attachment points, sliding scales, one-shots, parametric sideways covers, stop-loss instruments.

The possibilities in parametric risk transfer are becoming much, much broader. Ultimately that’s good for the buyers and for the capacity providers as well.

All of these innovative risk transfer approaches can help to minimise and mitigate basis risk.

Most important is starting with a clean sheet, to look at a clients risk transfer and deconstruct the program or tower, only to then build it back up with elements of responsive parametric protection at its core.

We need to see more of this, as through this process (if a client is kept fully-engaged) the education that will be gained into their true need for risk transfer and risk capital, learning what type of protection and capital injection they need and when it will be most helpful, can actually make their entire program more efficient.

It is amazing what you can learn when you deconstruct the risk transfer structures of the past and look to rebuild them to include modern techniques and efficient responsive capital.

Which is why we’d say, don’t blame the basis risk. There are now a multitude of ways to manage and reduce it.

More importantly though, if parametric risk transfer is approached as part of a holistic overhaul of programs and towers, it often makes much more, perhaps perfect, sense as to where it should be integrated.

Some insurance programs and reinsurance towers haven’t changed in years, perhaps decades, and when they do, the change is not always with a view to modernise and incorporate responsive, modern layers of earnings and capital protection.

All of which is to say that education remains the main thing holding back parametrics, in our view. But it’s changing and improving, fast.

That and a lack of ambition in some quarters, it’s often simpler to stick with the structures that are known and accepted. But thankfully, the growing breed of parametric specialists and increasingly innovative specialists in brokers and re/insurers are beginning to change things.

One day we may not even talk about basis risk any more.

It will still be there. But, with education and ongoing modernisation of our approaches to and structures for risk transfer, as well as use of advanced tech, the basis risk just might not matter as more intelligent, responsive risk transfer becomes the norm.