The power of parametrics
Insurance is a unique business where the interests of the insurer and the customer are sometimes misaligned. Parametric triggers can resolve this problem, making insurance truly customer-centric, say Mark Roelands of Roelands GRC Consulting and Marcus Schmalbach of Ryskex.
“All that is required to be demonstrated is simply that the event happened, not what caused it nor what harm resulted.”
Mark Roelands, Roelands GRC Consulting
“Parametric insurance has the ability to improve this relationship by avoiding arguments about causality and valuation.”
Marcus Schmalbach, Ryskex
Customer-centricity is a sales and marketing concept that focuses on the customer and not the product. It defines the value chain in such a way that it starts with the customers, making their expectations, needs and wishes the starting point for marketing measures. A product-oriented approach becomes a customer-oriented approach.
Customer-centricity is more than a service or a sales channel: it includes corporate culture, strategy and philosophy in one. The concept extends to all areas of a company and requires concessions from all employees along the whole value chain. Companies of the new economy, such as Apple, Facebook, Amazon, Google and Tesla, follow this approach, and their success proves them right.
Startups, in particular, see in customer-centricity a possibility to prevail against established companies, because they do not have to change their culture, but can align their strategy with the wishes of the customer right from the start.
According to Tatjana Winter, an expert on digital transformation, the captive insurance industry lags far behind other industries and has not yet successfully completed the transition to customer-centricity.
“Some of our cross-industry projects with the background of digital transformation showed that this is particularly associated with customer-centricity and that it is the key to sustainable success.
“Your most unhappy customers are your greatest source of learning.” Bill Gates
“The insurance industry, on the other hand, is constantly trying to combine new technologies and old models,” says Winter. “This will become a problem in the medium term as insurance stagnates in an ever-changing world.”
In return, some innovation managers of traditional insurers are frustrated. Thoughts are constantly being given, and products are being developed, that unfortunately fail in the market. Why? Because while innovations from insurance companies may be well thought-out, they tend to put their own interests at the centre of the process.
No other industry works like an insurance company, where you sign a contract with the customer and receive a premium, and then hope not to hear from them again until the end of the contract period. This somewhat unusual relationship between the insurer and the customer presents an extreme challenge. On one hand, one wants to win customers and make an attractive offer; on the other hand, one hopes that the damage will not occur.
Mis-sold insurances are a prime reason for insurance complaints, meaning unclear wordings and differing expectations. This can be as high as one of every two complaints, according to Hargovind Dayal in “The Fundamentals of Insurance: Theories, Principles and Practices” published in 2017.
Bill Gates, the former chief executive of Microsoft, once said: “Your most unhappy customers are your greatest source of learning.” How can this lesson be applied?
The self-interest of insurers (a low combined ratio) can be reconciled with a customer-centricity approach by switching to parametric solutions.
When the Albrecht brothers split their Aldi supermarket empire into south and north, they laid down the following rule: one divides, the other chooses. Why not make use of this approach in the insurance world? One brings the idea, the other prices it.
In the captive insurance sector in particular, professionals work on both sides. Accordingly, the following approach is conceivable. The captive owner clearly defines what it wants, and the reinsurer decides whether to cover the risk, and at what price.
Some might argue this won’t work, or will lead to eternally long negotiations and discussions, or would not actually change anything. They would be wrong.
Indemnity insurance vs parametric risk trading
Traditional insurance is based on the principle of indemnification: a demonstrable loss against an asset.
Take property insurance, for example. A factory will be in a particular location of a known size and built from specific materials which makes its asset value fairly easy to establish.
If the factory burns down, a loss adjuster can estimate the damage (which will take some time), and this can be used as the trigger for the claim payment.
With parametric insurance, the payout is not linked to identified damage but instead to an index or set of parameters that gauge the severity of the event.
A loss adjuster will ask many questions in the claims process such as:
- What caused the damage?
- When did it happen?
- What items were damaged?
- Can the insured prove a loss?
Parametric insurance does not require such questions. The simple fact that an index reached a specified level is enough to trigger the claims payment.
Examples of parameters that can be used as triggers are rainfall volume or seismic intensity. So, for flood insurance, if the rainfall volume in a particular area exceeds a defined number, a payout will be made without having to demonstrate that any flood damage has occurred.
Likewise, in an earthquake scenario, if the seismic intensity exceeds, say, 7 on the Richter scale a parametric insurance contract will pay out—even if there is no loss to compensate. With increasing availability of detailed data as well as analysis techniques the triggers can be tailored to the customer’s risk profile.
A claim is the moment of consummation in an insurance relationship. After all, that is the real product that is being sold. Parametric insurance has the ability to improve this relationship by avoiding arguments about causality and valuation and delivering a speedy payment.
Knowledge, trust and price have been identified as three reasons why customers might not be buying traditional insurance. Parametric insurance can deliver improvements in all three:
- Knowledge: parametric insurance is more transparent as it is based on a single identified numerical value equally understood by both parties.
- Trust: no tricky ‘small print’ or obfuscation around exclusions, causes or damage. Payouts are streamlined and much faster, with speed being of major importance (especially in a COVID-19 environment, where liquidity is crucial).
- Price: by eliminating underwriting and claims settlement costs, these savings can be passed on to customers in lower prices.
“Knowledge, trust and price have been identified as three reasons why customers might not be buying traditional insurance.”
These are not the only benefits to parametric insurance. There is a greater time flexibility, as the contracts can be tailored for specific scenarios and do not have to be renewed annually. The normal insurance annual cycle requires exposures and asset values to be changed every year, based on accountants’ reports and the like.
Parametric insurance has no such limitations because it is not linked to underlying assets. Contracts can also be shorter than one year, for example, covering just the Christmas shopping season or summer holiday periods.
Parametric insurance is based on inclusion rather than exclusion. A traditional insurance wording starts with a base premise and then carves parts out through detailed exclusions, deductibles and limits. The parametric approach remains at a high level. All that is required to be demonstrated is simply that the event happened, not what caused it nor what harm resulted.
Traditional insurance is well suited to high frequency, low severity events aimed at households and small business. A multitude of small-scale losses are easier to model and manage due to the richness of historic data and the fact that the law of large numbers will enable accurate macro level predictions.
Parametric insurance complements this traditional approach to improve the efficiency and the effectiveness of cover. Parametric insurance in the past has been focused on low frequency, high severity events. It was initially developed in the form of catastrophe bonds to provide extra reinsurance capital for major disasters.
Global capital markets dwarf reinsurance markets in terms of capacity. The Aon “Reinsurance Reinsurance Market Outlook 2020” estimates the global pool of reinsurer capital is $532 billion. This is tiny when compared to the global equity market of $75 trillion, a global bond market of $100 trillion, and a global derivatives market with a notional principal value of $700 trillion (Figure 1).
Figure 1: Market overview: capital market vs reinsurance/ILS market
The massive derivatives market is very familiar with parametric triggers, since that’s what drives its options contracts. Capital markets, with much deeper pockets and a long familiarity with the underlying concepts, is a natural bedfellow for parametric insurance products.
With the strength of the capital market, risks that are inefficiently retained and priced can be carved out of traditional insurance products and transferred efficiently to the capital market. New types of yield and returns are actively pursued in the capital market making parametric insurance-based products very attractive.
Link to customer-centricity
Let’s go back to our example of the Albrecht brothers and their discount grocery empire. Let’s replace them with a captive manager and an investor. We basically assume a parametric solution. Here, it is up to the captive manager to define the amount of the sum and the triggers for the claim.
Imagine a company wants to insure $50 million in case of an earthquake in its region. The trigger is the magnitude of the earthquake and the loss is deemed to have occurred when the magnitude is reached and confirmed by the government as an independent third party.
The price can be fixed on the basis of experience with traditional insurance policies, or you can orientate yourself on the insurance-linked securities (ILS) or industry loss warranty (ILW) market.
Yields on catastrophe bonds range from 2 to 20 percent, according to the InsuranceLinked website. The Eurekahedge ILS index has annualised returns pegged at around 4 percent—a more representative figure. In an environment where a quarter of the global bond market is offering negative yields, these are attractive rates—and sufficient capital is available.
Instead of submitting to long and often tough negotiations with traditional reinsurers, the captive manager can “share” the risk or “communicate” its terms to the market, and a risk investor can choose the risk in whole or in part.
The result is the final stage of customer-centricity, because the captive no longer buys insurance cover, but sells its risk to the capital market. The buyer becomes the seller.
A captive insurer is perfectly placed within an organisation to pool risks and transfer efficiently as a centralised hub. This will increase the importance of the captive as well as the captive manager within the organisation. In this perspective, the captive insurer is of great added value to the business, selling risks which can’t be retained efficiently.
The introduction of this article may have led some to believe it would be another attack on the inertia of the insurance industry, complete with the usual recommendations for action. However, it turned out that it is not the insurers who have to make the change: captive managers can create their own market.
This is about putting one’s own mindset to the test, and no longer seeing risks as an evil but as a product. In a world where commodities, shares, currencies and so on can be traded, the question arises: why not trade in risks? The basis is formed by parametric solutions.
Some people will think this is all well and good, but how do I get my risk nicely packaged in the form of a swap to the capital market? And will technological innovations such as blockchain, artificial intelligence and platform solutions help me do so? The answer is yes.
Marcus Schmalbach spoke alongside John Donald from Axis Capital and Karen Hsi and Courtney Claflin from the University of California on the panel “Digital Transformation of the Captive Insurance Industry” as part of the VCIA Virtual Conference in August.