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Index-linked insurance helps reduce adverse selection: Swiss Re


September 13, 2016   by Canadian Underwriter


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A reinsurance program can help mutual insurers free up funds that can be spent elsewhere, while index-based insurance can help provide coverage for business interruption not caused by property damage – such as software and electrical power failures – Swiss Re Ltd. suggested in a recent report.

Electrical power grid in silhouetteSwiss Re released Monday a sigma study titled Strategic reinsurance and insurance: the increasing trend of customised solutions.

The Zurich-based reinsurance carrier noted there is “a significant protection gap in property risk and demand for natural catastrophe covers is increasing.”

The report includes information on strategic reinsurance programs.

“Index-based or parametric insurance can make unique or difficult risks more insurable,” Swiss Re said in the report. “Unlike indemnity-based insurance, which pays claims based on individual loss occurrences when a loss report is submitted by an insured after an event, index-based insurance pays claims based on a parametric trigger such as when rainfall or wind speeds reach a pre-determined level. Because the index-based risk transfer relies on an external parameter reference, the solution only works when the reference index is highly correlated with actual losses.”

Index-linked instruments “reduce adverse selection since payments are based on information that is widely available,” Swiss Re stated, adding there is also “less need for in-person risk or loss assessments.”

Parametric insurance could be useful for non-damage business interruption (NDBI), Swiss Re suggested.

Traditional business interruption coverage is linked to a property policy and covers extra losses or expenses while property is being repaired, Swiss Re explained. Examples of NDBI include power failure, labour disruptions, failure of Internet access and software errors.

With incidents like those, there is “difficulty in properly assessing exposures,” Swiss Re warned. “The disconnect of NDBI risk from traditional property risk gives rise to asymmetric information and a lack of data, often making it impossible for an insurer to underwrite and price the risk. Here parametric products can be used to facilitate NDBI covers.”

Swiss Re explained three “motivation areas” for strategic reinsurance product: structured solutions, non-traditional reinsurance for corporate finance purposes and customized reinsurance.

The reinsurer gave 10 examples of non-traditional reinsurance solutions.

Mutual insurers in “lack the ability to raise capital by issuing equity as stock companies can,” Swiss Re said.

“Reinsurance can help mutuals manage their balance sheets and steer their business, which may be especially helpful in a market that is consolidating,” Swiss Re said in the report. “The reinsurance program reduces risk exposure, freeing up capital that can be redeployed elsewhere in the mutual business. At the same time, risk transfer through reinsurance safeguards against threat scenarios that could cut into the capital base.”

A lack of capital from external sources “leaves mutual insurers with fewer options to address regulatory/rating pressures should they need to re-build capital quickly in the event of significant losses, “ Swiss Re noted. “The difficulty in raising large sums of capital may also restrict the flexibility of mutuals to expand their business. In particular, mutuals cannot enter new geographies as easily as stock companies. “