New approaches to risk transfer need to be explored and developed to fill coverage gaps in the face of increasing climate-related risks, argue MMC’s Alex Bernhardt and Carolyn Kousky of UPenn’s Wharton Risk Management and Decision Processes Center
Disaster costs in the US have been steadily increasing over the past several decades. Insurance can speed and strengthen recovery, provide financial resilience and help improve both household and community-level outcomes post-disaster.
Despite these benefits, only about 50 percent of direct disaster costs were insured in 2019. Standard property policies may fully exclude certain natural hazards, exclude certain categories of disaster losses, or may have high deductibles or lower coverage limits for disasters. In addition to property losses, disasters can also cause significant economic impacts from unexpected unemployment, lost revenue to businesses where operations are disrupted and municipal fiscal losses, none of which tend to be insured.
In the face of growing climate-related risk, it is time to examine whether innovations on standard insurance models can help build greater resilience. Enter parametric insurance, which pays claims based on an objective measure of a hazard rather than based on loss adjustment. For example, for a parametric hurricane policy, it might be designed to pay the policyholder a set amount when windspeed exceeds, say, 75mph, at the insured location regardless of what the actual damage is to the property. This structure means that parametric policies can pay rapidly and disputes over payouts are greatly reduced. The payouts can also be used flexibly for any post-disaster need.
The drawback of parametric insurance is basis risk – or the risk of claims payment mismatch with losses incurred. This can make parametric insurance a poor replacement for indemnity insurance, where guaranteed compensation for full losses is needed (of course, indemnity policies themselves will also contain deductibles, coverage limits and other restrictions). However, parametric policies can be a handy supplement to traditional risk transfer in circumstances where cost, speed and flexibility are more important than indemnification. Specifically, three promising applications of parametric insurance meet these criteria when it comes to improving financial resilience to disaster losses: (1) as a supplement to traditional indemnity coverage for households and businesses; (2) as a means of financing short-term disaster relief expenses for local and state governments; and (3) providing coverage for low-income communities where indemnity insurance is otherwise unaffordable or unavailable (see table).
1. Parametric insurance to supplement traditional household and business indemnity coverage
Current indemnity-based property insurance policies for homeowners, renters and small businesses in the US often leave gaps in coverage. For a homeowner, this could be the complete exclusion of some disaster perils, such as flood and earthquake, or it could be much higher deductibles, such as for hurricane in the southeast. Other gaps in coverage could include uncovered damages, such as debris clearing or damage to landscapes; additional living expenses (this may or may not be fully covered in standard homeowners policies); as well as non-property-related losses, such as evacuation expenses or replacing lost income. Additionally, there can be an immediate post-disaster need for funds to support recovery before indemnity insurance policies have had a chance to settle.
For commercial insureds, particularly SMEs, similar gaps in coverage can emerge. The most significant gap in traditional commercial indemnity coverage relates to contingent business interruption (CBI), which is insurance that would cover losses to business even if the property or assets of the firm are not themselves damaged. While commercial property insurance policies will typically include coverage for business interruption if damage to the insured property prevents the business from operating, this coverage typically will not apply if a key supplier or essential piece of community infrastructure is knocked out due to a disaster, even if this, too, causes business interruption losses. While some indemnity insurers do offer CBI extensions to traditional policies, where it is offered, the limits available may not be sufficient to cover potential exposure.
A parametric insurance policy could be used to ensure funds are available to cover any or all of these types of losses. In this way, it would be a complement to a standard property policy, not a substitute. Indeed, there are now a few parametric products on the market aimed at households and which are structured to provide additional coverage beyond typical homeowners or renters insurance, such as Jumpstart for earthquake events in California and the StormPeace hurricane offering in Florida.
2. Parametric insurance for local governments to fund immediate disaster relief/recovery expenses
Disasters create a range of unpredictable and immediate costs for local and state governments. These can include emergency response, debris clean-up, inspecting residential and commercial properties and assisting residents in multiple ways from support and guidance to funds for repairs. In addition, local governments could see a decline in tax revenues, particularly if property destruction is widespread. While public entities typically have a host of disaster financing options at their disposal (Figure 1), parametric policies can play an important role in providing fast post-disaster liquidity to speed recovery. This will be most useful when sub-units of governments cannot rely on having all their financial needs met by federal funds, emergency management reserves, or budget reallocations. Indeed, federal resources are only available for the largest disasters that result in a presidential disaster declaration and many federal funds take weeks to even months or years to reach the locality. Parametric insurance can fill this timing gap.
3. Parametric insurance to address affordability and availability
One of the benefits of parametric insurance is that it can be developed and administered with lower expenses as compared to indemnity policies since underwriting and claims management require no in-person activity. This means parametric insurance can be used to provide coverage at lower limits than would be cost-effective for indemnity policies. As such, parametric insurance has been used around the world to provide financial protection to lower-income households. This is often referred to as microinsurance.
For these households, affordability and speed of payout are most important, and when designed carefully, basis risk can be reduced. For instance, some microinsurance schemes reduce basis risk by making use of a third-party, such as a non-governmental organisation or cooperative, that holds the insurance and disburses funds to individual constituents according to need. While microinsurance models have not been widely piloted in the US, there are many opportunities for communities to consider developing such programmes, particularly where disaster risk is pronounced and traditional catastrophe insurance premiums may be unaffordable for swathes of the population. While the lower expense of parametric policies may make them more affordable for low-income population segments, the community may nevertheless wish to consider some form of means-testing to support purchase, at least initially.
Parametric policies can also help in making coverage available in commercial insurance markets where indemnity insurance has proven difficult or costly to secure. This could be due to recent large loss activity, such as wildfire property insurance along the wildland urban interface. Where risk appetite in indemnity markets diminishes, an opportunity exists to structure parametric solutions which tap alternative capital sources and may reduce the overall cost of risk subject to the insured’s comfortability with the basis risk incurred.
As the planet continues to warm, we will face increasing climate-related risks in the coming years. In order to help manage these risks and improve resilience, new approaches to risk transfer will need to be explored and developed. In particular, the property insurance market will need to shift from providing one-size-fits-all products to offering a wider variety of policy types to meet various risk management needs. As the role of insurance expands to meet a broader array of climate resilience goals, parametric insurance has an integral role to play in filling traditional coverage gaps, providing fast and flexible liquidity, and offering affordable cover when indemnity policies are not widely available.