Parametric 2.0 – The developing insurance world

Moving to a world where the subjective becomes objective, the manual automatic, and the future foreseeable seems a scenario better reserved for science fiction than insurance.

Yet such a place already exists, and companies including AXA are helping define the journey.

The concept is parametric insurance, a notion that has been around since the 2000s, but the combination of digital innovation, technological ubiquity and economic necessity has created the optimum climate for its flourishing.

Climate, in fact is largely responsible for its evolution to date. Parametric, or index insurance products pay claims based on specific, defined triggers. The most common example – and upon which the market is largely based – is the weather: A hurricane with a force of 120 mph winds hits Florida; the insurance contract pays a predetermined amount based on the severity of the storm, not the actual cost of repair. A standard claim could take months to resolve, by which point the work to bring business and communities back online has either been completed, and financed by other means, or delayed.

It is clearly a sub-optimal arrangement, depriving government and its agencies of capital they desperately need to deploy in the immediate aftermath of the event. A proposition that can channel funds quickly could materially change the landscape. For businesses, parametric protects against not just revenue loss, but increased costs and damage that could impact anywhere in the value chain.

From natural disaster to mass market

Parametric insurance was first trialed in the 2000s and solutions have been increasingly adopted by governments and NGOs to support humanitarian disaster management, while some countries have created mutuals that cover predefined hazards.

In the past decade, parametric solutions have spread further among emerging markets, the public sector, corporates, and most recently, smaller businesses. Even the mass market is now under the parametric umbrella, with products for flight delay being released in recent months.

The biggest parametric sectors are renewable energy, agriculture, tourism, transport, textiles, leisure and construction. In fact, with three in four businesses impacted by weather – amounting to 30% of Europe’s GDP – it is easy to see why weather has dominated the parametric narrative to date. The frequency of weather ‘events’ is forecast to multiply five-fold in the next 40 years, according to the Intergovernmental Panel on climate Change (IPCC).

Despite this, winds of change are starting to blow, with opportunities existing not only in new sectors and developing markets, but ones as old as the hills – and ripe for optimisation. It is a crucial distinction.

Take, for example, the UK’s largest brewer Greene King, which saw recent profits hit by a typically soggy British summer. Shares slumped 16% on the news. With parametric cover, this kind of seasonal challenge could be more effectively managed.

For insurers, focusing efforts in the parametric and related spheres makes a great deal of strategic sense. Those with significant growth ambitions are examining opportunities to create new products and services while trialling new, data-driven processes and distribution channels enabled by technology.

Parametric, which epitomises this opportunity, is just one component of AXA’s broader strategy into emerging technologies and markets. It also sits neatly at the intersection of two industry megatrends: digitisation and the rise of new product models including microinsurance and smart contracts.

The interplay of rapid technological advancement on the one hand, and economic and strategic challenges (diminishing investment returns, globalisation and the interconnectedness of risk and growth) on the other has created a platform for a paradigm shift. To an extent, this is already underway, with larger primary insurers and reinsurers transitioning to data-driven risk advisors, offering a wider suite of services and ultimately playing a crucial role in fostering resilience on a global economic scale.

This starts with the management of the impact of catastrophe, the aforementioned birthplace of the parametric model, but could go much further.

“On top of the insurance product specifically, we’re helping our customers understand weather sensitivity. There’s a consulting aspect there that we can provide, in partnership with brokers,” says Madeleine Latapie, marketing and development manager for AXA Global Parametrics. “First, we’ll help our clients better understand and prevent weather risk, and then we’ll transfer that risk if it presents an exceptional threat.”

Parametric advantage

Parametric insurance pays using a proxy for loss, not the specific loss itself. This could be a specific event (say a hurricane) or when a parameter, such as an index, hits a threshold. The parameter correlates to the client’s losses – either directly (such as crop losses) or indirectly (business interruption). This allows for a wide range of risks to be covered; the pool is proportionate to data being available to map a risk, which has increased exponentially in recent years.

“New indexes are constantly being researched and used, looking beyond the weather and using data including from Internet of Things (IoT),” Latapie says. “So long as there is a strong enough correlation between the index and the client’s losses, theoretically any index-based insurance product can be possible.”

The first advantage is speed. The use of an independent trigger largely eliminates the need for a loss adjustor, or even an agent to manage the policy. One of the most cited case studies is that of Hurricane Matthew last year, the first Category 5 storm in almost a decade. Parametric triggers allowed over $30m dollars to be paid out within just two weeks via the CCRIF SPC, formerly known as The Caribbean Catastrophe Risk Insurance Facility.

By virtue of efficiency, risk mitigation and risk transfer, parametric creates what AXA Global Parametrics’ chief executive officer, Tanguy Touffut describes as a ‘win-win’ scenario. Firstly, for the insured, like the farmer who cannot wait to be paid in case of a drought destroying crops; secondly the insurer, who can better model and price claims, and who no longer faces claims handling costs; thirdly, for banks and financing components of the supply chain, and finally for governments and agencies attempting to build economies and increase resilience. In addition, in creating a more transparent, measurable and stable system, options for tapping financial markets, specifically LS (Insurance-Linked Securities) – financial instruments whose value is driven by insurance loss events – are created.

“For investors in renewable energy projects, for example, it’s appealing from a ‘smoothing’ perspective, and to guarantee return on investment,” says Latapie.

While the policyholder benefits from rapid payment, the insurer gains greater certainty and limits in terms of loss modelling and forecasting. Both gain from a reduction in moral hazard, adverse selection and frictional costs. The latter has massive implications: It means parametric products can be created in markets previously deemed uninsurable, and can also be applied to sectors where margins were so low to be prohibitive.

Freeing up the chain

Observers believe that cat bond investors have an increasingly healthy appetite for parametric deals, but this has been offset by reluctance on the part of issuers to absorb basis risk – effectively exposures that cannot be measured, or more specifically indexed, and thus covered – under the parametric model.

That gap has closed. In 2011, Parametric-based triggers for cat bond transactions – consisting of either pure-play parametric solutions or hybrid models – comprised around a third of the market. AXA believes their share has risen materially since then.

“Since the turn of the decade, huge improvements have been made in terms of data points and processing methods,” Latapie adds. “With the launch of new satellites, for example, and working with data from organizations such as NASA, we have access to much more granular data worldwide. We can use this in our contracts.”

This reduces basis risk (when index measurements do not match an individual insured’s actual losses) to practically null, and largely negates the primary criticism of parametric solution in the past – the possibility that policyholders will not always be covered for damages incurred.

If parametric penetration has been historically impeded by data upon which to base parameters, its future success is, to an extent, dependent on something else entirely.

Insurance ‘disruption’ has become to some extent a byword for innovation, yet few technologies or products exist that can serve the previously unserved. The specific application of blockchain to insurance is both colossal and cascading. It includes drastic simplification of the claims process, more efficient pricing, and enabling the creation of highly specified covers. This will have a disproportionate impact on populations who live in regions exposed to catastrophe, and as we have seen, these applications also happen to be necessary enablers for parametric models. The next phase requires insurers to champion it.

The AXA Journey

Since the launch of a parametric department in 2014, AXA’s parametric footprint has spread to clients in over 30 countries, spanning dozens of sectors, and working with all types of actors from governments, to international institutions, to businesses, SMEs, and individuals.

To accelerate its development, AXA launched a dedicated business unit, Global Parametrics, in March 2017. The company describes it as a “key enabler” for selected initiatives, supporting the Group’s innovation division and other AXA entities – created as part of a wider organisational restructure in May – part of which is “accelerating [its] blockchain ambition for a more transparent and seamless customer experience.”

A few recent examples include a partnership with the World Bank Group on a program covering the Philippines against typhoon risk. The parametric team also supported the launch of fizzy, AXA’s first live retail product combining blockchain and parametric insurance, offering travelers automatic and secure flight delay covers directly from their mobile devices.

The plan is to build out the parametric function leveraging the Group’s global footprint. China, for example, where AXA Global Parametrics is active, provides a platform in more ways than one. It is home to one of the biggest parametric players, and biggest insurers, in the world – ZhongAn.

The Chinese company’s vast scope and resources, coupled with a lighter regulatory regime, has allowed it to iterate and experiment. This includes parametric products focusing on the mass market. Fed up with the discomfort of successive and unusually hot summer days? ZhongAn has a policy for that.

Planting the seed

When working on solutions to increase resilience in developing countries, AXA’s approach is to work with global organisations to develop capacity and coverage. These include a Group-level partnership with the IFC-World Bank, described as one of the most extensive public-private ventures of its kind. This also includes a sub-partnership between AXA Global Parametrics and the Global Index Insurance Facility (indexinsuranceforum.org) aimed at increasing coverage for smallholder farmers in developing countries.

Building on an existing network of established relationships, including multinational NGOs spread across the globe, is more strategically viable than attempting to build the business on a direct or disintermediated basis. For obvious reasons, not least relying on scientific triggers as opposed to politically influenced decisions for aid, these organisations are proving increasingly receptive.

Touffut says global entities such as governments and international institutions are increasingly seeking to distribute sustainable insurance solutions such as parametric insurance as a means of sustaining GDP. Additionally, agricultural banks and other actors such as seed and fertilizer distributors are seeking to include parametric solutions in a bundled package, together with loans and inputs.

“Generally we don’t go in alone,” adds Latapie. “We prefer to use what we call a ‘meso’ approach, leveraging existing channels and partnering with local players.

Insurers have been reticent to directly enter into such markets historically because the setup, operational and distribution costs are too high to justify developing affordable products.

“In developing countries there exists a protection gap. There’s demand for but little traditional insurance coverage,” Latapie continues.

“Why is that? Because, generally, traditional insurance is too costly — both to put in place for the insurer and to afford for the smallholder farmer.”

Essentially, the parametric approach simplifies the insurance chain, largely eliminating expensive and time consuming functions, which are ultimately loaded onto premium. Consequently, many types of players, including small businesses, can benefit.

Pocket Parametrics

Indeed, the role of technology in the parametric story is not limited to classic use cases of satellite imagery of crop damage; nor to blockchain coding and delivery of parametric contracts. Distribution is also a key component. Reaching populations previously either uninsured or uninsurable is now possible because these covers can be delivered via a swipe of a phone. Latapie refers to this as ‘pocket parametrics’, and it is core to the other part of the business, such as the Group’s innovation center, with which the parametric team works.

“We are building products where you can take out your smartphone and subscribe to your insurance for a specific risk for short term coverage,” she says.

As a result, there is opportunity for mobile phone carriers to effectively become intermediaries. This, coupled with other channels, from lenders to group policies for mutuals and associations, and index-based insurance for government and the public sector in its entirety, the parametric platform appears well positioned. And it doesn’t stop there.

Parametric 2.0

Parametric has begun to prove its value to retailers, but with the ZhongAn example in mind, the future suggests it could be turned to the development of retail products too.

“In the years ahead, we’re going to see more research and development looking at parametrics,” says Latapie. “We’re currently aiming to develop more retail products with IoT, moving beyond traditional weather-sensitive indexes to parametric 2.0.”

In September 2017 AXA launched fizzy, a flight delay product, where claims are paid automatically if flights are delayed by at least two hours. Suddenly parametric is going mainstream, and in this case, could help solve an obvious consumer pain point.

With seemingly all markets and customer segments in play, what is the parametric bottom line? Though AXA cannot disclose growth numbers or targets, Latapie says the business will increasingly focus on individual customers, including retail parametric products. She expects the business structure to continue to evolve, and rapidly too, while looking at new product executions, models and widening the scope of indices.

The company says parametric has already proven a high growth startup business over the past two years, but by virtue of its operating model – customer experience-led, process efficiency driven, and by “amplifying the scope of the insurable” – will help propel the group’s transformation to the digital age.

As parametric penetration continues to rise, the response of the ILS market will also be closely scrutinized. Given data is empowering investors to move closer to risks, commentators suggest the omens – and the opportunities – are good. As data availability, market appetite, product set and distribution mature, capital will likely follow. And alongside other forms of evolving insurance, with its global societal potential the evolution of parametric could be well considered a barometer for the future of insurance.

Part of that future is looking back, and looking differently, at an age old problem. As Touffut says: “It doesn’t matter what line of business you are in, nor where, nor how developed your economy and infrastructure is. Wind turbines or winemaker, what you cannot control is the weather. No one expects that. But controlling the financial fallout is increasingly expected.”

To an extent, the vision of an entirely predictable, and entirely automated world remains science fiction. But short of influencing the weather itself, forecasting, understanding, and ultimately mastering its impact is surely the next best thing. The journey has begun.