Cedric Stephens | Traditional indemnity versus parametric insurance

QUESTION: What is parametric insurance? What are the differences between it and ordinary insurance? Is it locally available?

– R.M., Kingston 8

RISKS & INSURANCE: Thanks for posing three intriguing questions. Other persons who wrote me last week asked about cyber risks, insurance for agricultural vehicles and the usual problems about payment delays for claims for motor vehicle accidents that occurred years ago.

I chose your questions as the topics for today’s article. They are short, precise, and unusual. Also, they are directly connected to something that I read in last Wednesday’s Jamaica Observer, headlined ‘Jamaica Draws Down $500 Million Catastrophic (sic) Pay-out’. There is a link between it and this newspaper’s Business Reporter Karena Bennett’s piece on January 3 titled ‘Crop Insurance Back on the Agenda for 2021’. Both articles will help to answer your questions in a local context and a real-world example.

The United States insurance industry is state-regulated. Each state sets the rules by which insurers and intermediaries conduct business. All state regulators, or commissioners, have formed a body, called the NAIC, that sets industry standards. NAIC defines parametric insurance as “a type of insurance contract that insures a policyholder against the occurrence of a specific event by paying a set amount based on the magnitude of the event, as opposed to the magnitude of the losses in a traditional indemnity policy”.

Traditional or indemnity insurance and parametric insurance are different. Local insurance contracts, with one exception, are traditional. Parametric insurance contracts pay a pre-agreed amount when a pre-determined specific event occurs. Payment to the policyholder is triggered when certain data metrics, or parameters, can be independently verified. A defining feature of parametric insurance is that it offers fast, lump-sum payments, unlike traditional indemnity coverage.

Daniel Bretler and Timothy Gosnear, writing in Insurance Journal last January, defined parametric solutions this way: “Traditionally, instead of indemnifying for the actual loss incurred, parametric insurance covers the probability of a predefined event happening (e.g., a major hurricane and earthquake), and pays out according to a predefined scheme. Events may refer to an index-based trigger (e.g., crop shortfall) or an event within a defined area (often referred to as a ‘cat-in-a-box’).

“Exemplifying the cat-in-a-box concept, a policy might be structured to pay out 50, 75 or 100 per cent of a predefined limit for a Category 3, 4 or 5 hurricane, respectively, happening within a 30-mile radius around the client’s point of interest. The notion of ‘point of interest’ is an interesting feature of parametric cat-in-a-box solutions. The client defines a ‘point on the map’, that is, a longitude, latitude, or geographical coordinate. Hence, the cover is not limited to the insured’s locations but can also include infrastructure critical for the client. This provides policyholders with flexibility.”

Parametric insurance fills in gaps where traditional insurance falls short.

The recent $500-million payment to the Jamaican Government was made under a ‘2020/21 Excess Rainfall (Parametric) Policy’. It was placed with the Cayman-based CCRIF Segregated Portfolio Company,” according to The Observer. Finance and the Public Service Minister Dr Nigel Clarke said “the payout was related to the intense and persistent rainfall associated with Tropical Cyclone Zeta in October last year, and Eta, the following month in November, which caused the loss of lives and significant damage, particularly to the country’s road network.”

Put another way, ‘the loss triggers’ fell within the pre-agreed parameters stated in the contract. As a result, the pre-agreed amount, $500 million, became payable.

CCRIF SPC is not like the traditional risk-bearing institution found in New Kingston. It was created to limit the financial impact of natural hazard events on the Caribbean and Central American governments by quickly providing short-term liquidity when a policy is triggered. CCRIF offers parametric insurance policies for tropical cyclones, earthquakes, excess rainfall, and the fisheries sector. Twenty-three countries subscribe to CCRIF.

Many persons in Jamaica do not understand the concept of parametric insurance. They confuse it with indemnity insurance. Former senator and ex-Jamaica Agricultural Society president Norman Grant is one. He was quoted in Ms Bennett’s article as saying that “it is time the Jamaican Government pulls down on (which I interpret to mean withdraws) financing from the regional risk pooling mechanism, CCRIF, to which the country contributes significant sums of money”.

I interpret these and Mr Grant’s other comments to mean that he believes the country is wasting money by participating in CCRIF. That the sums of money saved would be better spent to finance a crop insurance scheme for farmers. Do his arguments have any validity in light of the recent $500 million payouts?

On the broader issue of an insurance scheme for farmers, one group of experts argued in 2020 that: “For a national agricultural insurance programme to be successful, the government should not be seen as a simple provider of financial support, but rather as a key player engaged in bridging the gaps underlying the market failures to which agricultural risk management is exposed. In this respect, some of the important roles that the government can play are to: generate conducive legal and regulatory frameworks; enhance data and information collection systems; enhance standardised methodologies for post-disaster damage and loss assessment, which may be relevant both for government disaster risk management and/or for agricultural insurance; foster education and capacity building; promote research and development; and support catastrophic risk sharing/risk financing.”

The choice facing the Government is not binary. Given Jamaica’s exposure to a wide variety of risks – as COVID-19 has shown – participation in CCRIF offers benefits.

The agricultural sector, which some experts say suffers losses of US$12 million to US$15 million annually, needs a mechanism to protect investments in the sector and promote economic growth. One of the solutions could include parametric insurance.

- Cedric E. Stephens provides independent information and advice about the management of risks and insurance. For free information or counsel, write to: aegis@flowja.com