For buyers of parametric reinsurance, cat bonds and industry loss warranties (ILW) understanding how payout triggers are built into the product design is the most essential part of the consideration process. There has been criticism recently towards catastrophe bonds in particular, in relation to how they will determine payouts, and this is especially pertinent when they are sold as a solution to fund disaster recovery in vulnerable locations. In addition, question marks over data provider Property Claims Services’ initial USD 5bn loss estimate for hurricane Milton have raised eyebrows and led the market to debate whether certain risk transfer products remain fit for purpose, as they might not adequately cover losses if they are based on inaccurate estimates.
The most recent example of this is Jamaica’s cat bond, which has been under scrutiny due to the very specific threshold for payout, which was narrowly missed despite the devastation that the storm caused to the island. The specific trigger conditions within the bond were indexed around the storm's central air pressure, which had to be met within any of the 19 sub-regions into which the country was divided. Whilst the hurricane passed through six of these, creating widespread damage across a significant proportion of the country, the air pressure remained at a level that was insufficient to meet the trigger condition. This left Jamaica with no payout under the product they had purchased to bring financial protection for this scenario.
Contrary to the difficult position that Jamaica found themselves in, many parametric policies that paid out in the aftermath of hurricane Beryl, including those designed by Augment Risk, instead considered the intensity of the event bringing greater certainty to the payout. The main trigger within these protections was based on wind speed and storm track. This meant that financial support was quickly available as soon as those thresholds were met, in some cases even before the storm had fully subsided, allowing those affected to launch clean up and recovery efforts without delay.
The harsh reality is that not all protections will provide timely help when they are most needed. It is fundamental to assess the scenarios, and to design a product that is tailored to meet the specific requirements of the business. In the case of cat bonds, the complexity of the criteria involved can mean either failure to trigger payout, as was the case for Jamaica, or a payout that turns out to be insufficient – in either case the financial support is only obtained after a long assessment period. ILW (also triggered by a pre-agreed threshold) are based on reported industry-wide losses. The complexity of their payout clauses can lead to discrepancies between the actual loss experienced by the policyholder and the industry loss, resulting in differences between expected and received payouts. Settlement delays are common here, too, as the industry assesses their losses ahead of confirming the event has triggered a payout which can trap capital, an additional headache vs parametric wind based triggers, which can pay within days of a hurricane occurring. Basis risk is always present no matter which product is chosen, but it can be managed and minimised. A well-structured bespoke parametric policy with a transparent view at the underlying index, which has been specifically tailored to the underlying risk, can help reduce this. Questions regarding the basis risk of ILW and parametric catastrophe bonds compared to pure parametric reinsurance policies are now being raised.