July 28, 2020 by Adam Malik
Parametric solutions may be a key way to close the pandemic protection gap — the gap between those who are experience losses due to the pandemic and those who have insurance coverage for it — but the solutions generally require finding capital, which may be a difficult task during an economic recession.
A recent white paper from risk analysis company PCS, Pandemic Parametric, takes a look at why a new approach to risk transfer is crucial to closing the gap. It examines how parametric risk-transfer industry loss warranties (ILWs) could be structured in a more effective manner to help insureds, insurers, and reinsurers better manage their risk and capital.
ILWs are common in the reinsurance market as a form of reinsurance for reinsurers. Insurers could use ILWs to supplement traditional reinsurance purchases. They’re useful and niche, the paper says.
Typically, coverage in an industry loss warranty is triggered by a third party reporting that an event has occurred, rather than by the insured indicating that it has experienced a loss, as Investopedia notes. “This is because the coverage trigger is not based off of the experience of the insured, and is instead based on losses over a wide number of organizations.” A trigger can also be linked to an index other than industry losses, such as the magnitude of an earthquake or the wind speed of a storm.
“When market conditions lend themselves to ILW transactions, there could be US$7-10 billion in limit out in the market (excluding catastrophe bonds that would fit the definition),” the PCS paper explains. “Further, ILWs generally don’t make their way to original insureds.”
A parametric ILW could help insureds address the gap, which exists because a pandemic is difficult to understand. While there have been outbreaks, none in recent times have been anything like COVID-19. The last event that was like the current pandemic was the Spanish Flu of 1918 — more than a century ago.
“Without sufficient frequency, there just may not be enough data points to support in-depth analysis,” the paper said.
And it’s difficult to insure. One may not happen often but it causes great economic loss — millions of people are out of work, vessels are stuck at sea for extended periods of time, oil prices became volatile, and consumer spending dropped off — and costs to the insurance industry could be staggering if a pandemic was insured to begin with.
That makes modelling difficult. Scaling a market for pandemic risk transfer would be based on thin insight. “In the extreme, one big loss could take centuries for an insurer to recoup, if they even manage to stay afloat after the event,” the paper added.
That makes finding new capital is difficult, the paper concedes. “Infrastructure is important, but in the end, a transaction has to make sense for both parties,” the paper explained. Buyers want affordability relative to the expected loss — not to mention the fact that coverage for a pandemic may not be included in existing budgets. Sellers, meanwhile, need a level of comfort that they’re being compensated enough for the risk they’re taking on, especially one for which its most relatable data point dates back to just after the first World War.
It will take some creativity, the paper said. “COVID-19 has brought what is literally a once-in-a-century learning opportunity. The risk-transfer techniques our industry pioneers today could be the first step future generations use a hundred or more years from now. With that in mind, maybe a proof of concept in 2020 wouldn’t be such a bad idea?”
Feature image by iStock.com/DNY59