Using Parametric Insurance to Close the Earthquake Protection Gap

Using Parametric Insurance to Close the Earthquake Protection Gap
Parametric Insurance

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Property Risk Management

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December 11, 2023 9 mins

Using Parametric Insurance to Close the Earthquake Protection Gap

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Parametric solutions have the flexibility to make hard-to-predict and often uninsurable “grey swan” events insurable. Such is the case for earthquakes — a potentially catastrophic risk across the globe.

Key Takeaways
  1. There is a growing protection gap for grey swan risks — including earthquakes — in traditional risk transfer markets.
  2. Businesses often struggle to quantify total economic cost and are therefore retaining risk, leading to high uninsured losses.
  3. Parametric cover — which is triggered by third-party event data rather than physical damage to an owned asset— provides broad and flexible event response to help offset uninsured losses.

Natural catastrophes are growing in frequency and severity across the globe, upending lives, businesses and infrastructure — and they are helping grow a protection gap that is leaving most disaster losses uninsured.1

According to Aon's 2023 Weather, Climate and Catastrophe Insight report, natural disasters caused global economic losses of $313 billion in 2022, outstripping economic growth. Insured losses lagged behind, accounting for just $132 billion. That’s a 58 percent gap, or $181 billion in uninsured losses.

This protection gap has continued to grow, along with uncertainty created by conventional risk transfer solutions as insurers grapple with runaway loss costs. Parametric insurance provides a response by insuring otherwise uninsurable “grey swans” with difficult-to-quantify economic impact.

Better Informed

The Challenges of Insuring Earthquake Risks

Catastrophic earthquake probability can be calculated, but the ensuing economic impact is difficult to measure. Unable to attach capital to transfer such risks, businesses often end up simply retaining them — with potentially devastating consequences.

This creates a “grey swan risk transfer paradox.” Events like catastrophic earthquakes are exactly why businesses should transfer risk. However, if there is insufficient data from an underwriting perspective, it can make sufficient risk transfer unavailable — and therein lies the paradox.

Without an action plan to close this growing protection gap in traditional markets, losses will likely continue to mount in a world of increasing extremes, as global trends indicate.

Though a catastrophic earthquake can be perceived as a low probability event, over a long time, horizon expectations of losses should be quite substantial. The last major earthquake in California was the Northridge earthquake in 1994. Over the next 30 years, the United States Geological Survey places the probability of a 6.7 quake (or higher) at 60 percent in Los Angeles and 72 percent in San Francisco.1 In fact, such hazards exist through the entire U.S. West Coast, as well as in Alaska, the Midwest (New Madrid Fault), and South Carolina.

Estimating the potential loss exposure from an earthquake also presents various challenges. Common complexities include:

  • Limited preparation opportunities

    Unlike relatively frequent tropical cyclones, catastrophic earthquakes offer little warning, and their frequency is uncertain. This also limits potential efficacy of catastrophe modeling given limited opportunities to test and refine models.

  • Interconnected risks

    In addition to affected premises and infrastructure damage, the impact of earthquakes can ripple out beyond businesses to stakeholders, such as supply chains, workforce and lenders.

  • Non-physical losses

    Beyond property damage, losses may include difficult to model non-damage business interruption, loss of attraction, and loss of ingress/egress — the inability to enter or leave the affected premises.

  • Uncertainty over the traditional claims process duration

    A major earthquake should be expected to put a strain on claim adjusters, extending the claim process that ties up capital relief.

“Many of our clients have found that even if their own construction quality is outstanding and direct physical exposure to catastrophic events limited, it doesn’t mean their business is not highly exposed,” says Pete Lacovara, managing director in Aon’s Alternative Risk Transfer and Innovation practice in North America “This includes employees who are adversely impacted by local infrastructure, making it difficult to work from home. Even if the office is not damaged, the workforce may not be able to use it.”

Better Decisions

Parametric: A Compelling Solution for Unexpected Catastrophes

Known unknowns like grey swan earthquakes are where parametric solutions shine. Unlike traditional insurance, the trigger for parametric cover comprises predetermined third-party parameters — such as an earthquake of a particular magnitude within a set geography — rather than physical loss to an owned asset as with conventional cover.

Instead of struggling to quantify the economic impact, parametric providers can objectively assess the risk at any given geography and attach capital to that risk to offset uninsured losses. Advancements in data and analytics have allowed clients to obtain cover for more perils with greater precision than ever before.

In catastrophe-prone areas where traditional insurance capacity is restricted, the broad coverage offered through parametric insurance is a particularly compelling fit. Parametric solutions are:

  • Independent

    Triggering parameters are measured and reported by a third party. Risk managers can clearly define events that will and will not result in paid claims, as well as the sum of those claims.

  • Fast

    Because there is a clear event trigger, claim settlement is quicker and more transparent. Coverage is usually confirmed within days and funds arrive within weeks — avoiding a complex loss adjustment process.

  • Flexible

    Any financial loss ensuing from a triggering event can be an indemnifiable expense under parametric insurance.

$181B

Uninsured global nat cat losses in 2022

Source: 2023 Weather, Climate and Catastrophe Insight

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Every entity exposed to natural catastrophe should have parametric solutions in their risk capital stack, because all risk has a grey swan component.”

Michael Gruetzmacher
Head of Alternative Risk Transfer and Innovation, North America
Bringing Traditional and Parametric Insurance Together to Close the Gap

With a parametric trigger, uninsurable exposures become more insurable. These solutions are an ideal complement to traditional property insurance. They provide capital for a wide variety of interconnected exposures, such as impacted suppliers, employees, and other stakeholders.

"With earthquakes, you have limited opportunity to prepare your business or employees,” says Lacovara. “There is very low insurance penetration for earthquakes on the West Coast for personal lines. Even if a company is buying traditional indemnity earthquake cover, it’s not guaranteed that their employees are. Maybe your buildings are fine, but your employees find themselves without a home. A parametric solution’s flexibility works well in these situations.”

Further, parametric insurance does not pose the same capacity challenges as traditional insurance, making it ideal for businesses that are unable to secure traditional cover. In a market where achieving meaningful contingent business interruption limits can be difficult, parametric cover provides additional limits for peak catastrophe risks.

Aon’s Thought Leaders
  • Michael Gruetzmacher
    Head of Alternative Risk Transfer and Innovation, North America
  • Peter Lacovara
    Managing Director, Alternative Risk Transfer and Innovation, North America
  • Colin Harper
    Managing Director for Alternative Risk Transfer and Innovation, North America
  • Kirstin McMullan
    Principal Consultant, Natural Catastrophe, Australia
  • David Gierski
    Property Broking Director, Europe, Middle East, Africa
  • Aurelien Schwachtgen
    Director, Client Solutions, Aon Global Risk Consulting, Europe, Middle East, Africa

General Disclaimer

The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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