An unexpected advantage
How can we provide for improved insurance protection in developing economies? Parametric cat bonds and index based insurance offer possibilities. Sometimes critics argue that this entails a lack of correlation between damages and payments. But is this necessarily a disadvantage?
In discussions on how to provide retail insurance in developing countries, a common conclusion is that weather index based insurance would be preferable. There are several reasons for this, including the difficulties of assessing actual damages from draught or flooding in these countries, the moral hazard risk of self-reporting when adequate control structures are not in place and, perhaps most importantly, the ability to guarantee rapid settlement of claims. These insurance schemes are the retail equivalent of cat bonds with parametric triggers, where the bond triggers on predefined conditions, such as precipitation (or lack of it), wind strength, or the central pressure of tropical cyclones.
The most common criticism against both index insurance schemes and parametric cat bonds is the lack of direct correlation between the indices used to determine payments and actual damages to crops. Crops could be damaged even if the index conditions are not met. And, conversely, some farmers will be able to recover crops and still collect payments if the conditions are met.
Yet, it is perfectly possible to consider this one of the greatest strengths of index insurance. With traditional indemnity based insurance, farmers facing a possible total loss of harvest may simply give up on rescuing parts of it. In many cases, this would be a rational decision, as insurance payments and profits from crops would be a zero-sum game. However, if insurance payments are paid on presumed damages and thus de-coupled from actual damages, individual farmers will still have a very strong incentive to rescue as much as possible even from a badly damaged harvest.
The same is, of course, true when applied to parametric cat bonds. A country, or a state, covered by one of these bonds will have every possible incentive to limit damages and to respond quickly to a natural catastrophe since these efforts won’t affect a future payment from a triggered bond.
From an investor’s point of view, parametric cat bonds and index based insurance have obvious advantages, as the triggering mechanism is very transparent and thus easy to model. While other trigger mechanisms have other advantages, such as minimization of basis risk (the insurer’s risk that reinsurance and obligations are misaligned, e.g. a parametric cat bond not triggering after a hurricane that causes considerable claims on the insurer), there are clear advantages to parametric solutions, particularly in developing economies.