Sustainability: Parametrics fill the gap

The Intergovernmental Panel on Climate Change (IPCC) anticipates that weather extremes will become more pronounced as a result of climate change. Consequently, the frequency and severity of some natural perils is expected to increase. 

Clearly, a trend towards more extreme weather would have significant implications for risk managers and the organisations they serve. Furthermore, other factors, such as sea level rise and the concentrations of risk in coastal cities, will only serve to heighten exposures.

Martin Hotz, Head Parametric Nat Cat at Swiss Re Corporate Solutions explains: «What we see historically is very clear and strong urbanisation, which is then amplified by ongoing climate change effects… Since 1980, the majority of rising losses associated with weather events has been due to exposure accumulation that comes with economic growth and urbanisation.

“The concentration of humans and physical assets like buildings and factories, particularly in urban areas such as low-lying coastal regions that are vulnerable to adverse weather conditions, inflates the loss potential when a severe weather event strikes. Other socio-economic factors account for most of the remainder of the trend of rising losses over time.”

The problem of protection gaps

The protection gap – the difference between insured and total losses – is already substantial, and the fear is that climate change and urbanisation could cause it to grow wider yet.

Hotz explains: “In 2019, the protection gap amounted to $86 bn globally, based on a recent Swiss Re sigma report. This highlights the ongoing under-insurance of society even with growth in insurance penetration.”

However, when it comes to the protection gap in commercial insurance, it is not just about whether companies buy insurance or not, or whether the scale of their cat program is sufficient to cope with rising extreme weather events. It is also about whether they buy the type of insurance that is right for them, and their individual exposure.

Hotz said: “How much protection through risk transfer is needed depends on many different factors, as some companies can tolerate higher risk levels and deal with more volatility than others. In commercial insurance, I would define the protection gap as the difference between the protection level that a company needs, and the protection that this company has in place, and how that protection reacts to external shocks.

“Over the past years and decades, the global economy has become much more interconnected, which for example increases the risk of contingent business interruption. This can be a huge external shock to a company, and is often difficult to address with traditional insurance.”

He says that insurers have a mandate to talk to their clients and make sure that risk managers have a comprehensive understanding of their potential protection gaps, whether that’s due to a lack of cover for intangible assets or a greater risk of business interruption than initially thought.

The rise of parametrics

As weather-related events continue to rise, and the impacts of these are heightened by a combination of urbanisation, intangible assets and complex supply chains – risk managers may need to turn to other solutions to ensure that they have the right levels of risk transfer in place.

In addition to traditional property catastrophe risk transfer solutions and the development of public private initiatives, parametric solutions offer significant potential as solutions for extreme weather risks.

These solutions are widely available for perils such as earthquakes or tropical cyclones, but the list of weather events that lend themselves to parametrics is actually far longer than that.

Hotz concluded: “Parametric solutions are fast, transparent and flexible. The latter is of relevance when it comes to filling protection gaps, as the payout from a parametric solution can be used to cover all losses resulting from the covered event occurring.”

“Consequently, ‘loss’ is not limited to direct physical damage and resulting business interruption. The comprehensive nature of a parametric solution allows it to address contingent business interruption situations, as well as many other situations where traditional insurance struggles – such as wide area damage, loss of attraction and recovery related expenses.”