Thursday 22 April 2021

In praise of parametric insurance

It's not quite the kind of parametric insurance offering I've been after, but it's getting closer to it. Bounce Insurance now provides a quasi-parametric earthquake insurance product. 

Individuals can get $10k or $20k coverage; businesses get up to $50k. 

If ground force acceleration in your neighbourhood exceeds the trigger value, then you get paid out. You have to attest to that you've incurred losses at least as large in value as the amount you've insured against; there's potential for spot audit later to confirm. But they pay out within days.

I wrote about it in this week's column for the Stuff newspapers.

Parametric products are much simpler. They are common in North America for crop insurance. Rather than forcing anyone to try to estimate the cost of a heavy frost for an orchard, the insurance simply pays out if temperatures drop below the trigger levels. And larger payments for harder frosts are possible as well.

These kinds of products are exceptionally well suited to earthquake risk. A major earthquake on the Alpine Fault is overdue. And, every year, there is about one chance in 120 that Wellington will get to enjoy an earthquake as large as the 2011 Christchurch quake. In that kind of scenario, it is hard to say exactly what losses any of us might experience – but they will be substantial.

If you own a downtown business, will your loss come from the building’s failure? From a neighbouring building’s failure? From council cordons around downtown that could easily last for a year? From depopulation? From blocked transport routes?

Your homeowners’ insurance could see your house rebuilt, after a lengthy process, or a cash settlement, which may be rather less than you had hoped for if there is argument about the extent of the damage.

If your job shifts out of town because your employer is leaving, you may be trying to sell a broken house along with its insurance claim, in a hurry, at the same time as many others are trying to do the same. If your home is your biggest asset, the loss will be substantial and is both uninsured and uninsurable.

A parametric insurance product does not care about the nature of the loss or about measuring its extent. If the insured event happens, payment comes quickly. Unfortunately, those wanting parametric earthquake insurance have had no options at all, until this year.

I've wanted a contract that pays a very large sum if a Mercalli VIII event happens. There are reasonable odds that Wellington doesn't recover from that kind of event. The Bounce product is an improvement, but still isn't quite what I'm after. It triggers on ground force acceleration of 20 cm/s, which they describe as matching strong to severe earthquake on the Mercalli rankings (VI or VII). 

I'm really after catastrophic coverage: a large payout for a very severe event. I'm not worried about my existing insurance coverage for Mercalli VI events. I am worried about what happens if downtown is cordoned off for a year and the city can never come back from it. So rather than $20k coverage against major and more minor earthquakes, I'd be interested in something more like $1m coverage against "death of the city" events.

I'd also worry a bit about the loss attestation provisions. It seems a way of squaring a near-parametric product with NZ insurance regulations that don't really want insurance products that look like event derivatives or financial instruments. But it could come back to bite if someone wants to argue the toss about the extent of loss after the event. 

I guess I fundamentally don't get why nobody's doing something like the following:

  • Define a set of catastrophe bonds for major quake markets. Wellington. Tokyo. San Francisco. Seattle. Vancouver. Taipei. Los Angeles. Tehran. Manila. Lima. Tianjin. Jakarta. Christchurch / Alpine Fault. Each bond would pay a margin over a global index's return, in exchange for the risk that the bondholder would be partially wiped out if the trigger event happens. Investors could have their funds split across the earthquake markets proportionately to demand in each of those markets for the insurance products. 
  • Sell insurance to people wanting parametric coverage in each of those markets. They'd have to pay investors their margin over the index fund's return for the risk transfer; that's what their premiums would be. 
  • Money from investors would just go into the index fund, ready to be liquidated to cover insured people's claims if needed. If, say, 20% of the insured value were in LA and the LA quake triggered, then that proportion of the fund would be liquidated to pay out the insured people, and investors would take that hit to the fund's value. 
  • Presumably premiums in any market could bid up if the accumulation in that market started getting high. 
I suspect a combination of thin demand and regulatory issues lead to missing markets. 

Wellington's median house price is now over a million dollars; there have to be tons of people for whom a house in an earthquake zone is their biggest asset, and they face massive uninsured and currently-uninsurable risk. But I doubt many have gazed long into the "Wellington gets an earthquake at least as big as Christchurch 2011" abyss and what it could mean. 

I understand there to be potential regulatory issues in these kinds of contracts; they're presumably the reason why Bounce has had to require that claimants certify that they incurred losses at least equal to the amount paid out. And while that's easy on small-scale stuff, it might start being a worry if you were trying to get a million dollars' coverage. Could you really prove, to an insurance standard, that you'd suffered a million dollars in loss because of the event - when nobody knows whether the city will be dead or whether it will bounce back? But the alternative might be considered to be a financial derivative rather than insurance, and then a whole different complicated bucket of regulation applies. 

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