Insurance-linked securities and parametric insurance cited as innovations by Swiss Re

The latest sigma report from reinsurer Swiss Re’s Economic Research & Consulting division takes a look at innovation in non-life insurance markets. The report says that although insurers are often seen as lacking in innovation there is actually considerable product innovation happening in the markets but much of it happens incrementally. Alternative risk transfer techniques, including insurance-linked securities and catastrophe bonds, however are an example of a more fundamental change in the sector.

The report discusses reasons for the lack of innovation in many areas of the re/insurance markets and tries to identify some areas where there is scope for more innovation to occur. A balanced approach to innovation is required, including both radical new initiatives and incremental product development to in order for innovative projects to be successful. Greater client centricity, risk-based pricing and further integration with the capital markets can play a vital role in encouraging innovation in re/insurance.

Two areas the report discusses are of particular relevance to the sectors we cover. On parametric insurance the report from Swiss Re says that the development of parametric triggers are one of the best examples of an incremental innovation in the market. Index-based insurance policies which pay out when the defined index hits a parametric trigger point allow compensation to more closely mirror the actual damage. Parametric triggers also enable a quicker claims payment process as the payment is based on, in most cases, weather data meaning there is less ambiguity in the process. This can enable the simplification of transactions.

While parametric triggers are prominent in catastrophe coverage and cat bonds they are also widely used in developing nations in microinsurance weather covers and really come into their own as a simple and understandable insurance product to protect the insureds livelihood from weather and catastrophes. There is much innovation to come in index-insurance and parametric triggers and we suspect that their use will grow as robust sets of data against which they can be measured become more widely available.

The other products of interest are naturally insurance-linked securities and catastrophe bonds. The report identifies them as part of the alternative risk transfer space and an innovation which has resulted in a more fundamental change in re/insurance. As products they have allowed re/insureds to spread their sources of cover to include the capital markets, share and distribute risks to those most willing to hold them, achieve multi-year protection where it was sometimes not available and introduced new players into the re/insurance markets.

The report says that capital market re/insurance solutions such as ILS and cat bonds are most suited to cases where there is more publicly available information about the risks (vital for risk modelling to be robust and transparent) and where the protection buyer’s exposure is more closely correlated to an independent index or price. This may explain the success in natural catastrophes the report says, a key driver in the ILS and cat bond markets development has been the availability of third-party modelling companies and tools.

As our regular readers will be aware, innovation is an ongoing process in the ILS and cat bond markets, only this year we have seen the trend towards private cat bonds and a number of particularly innovative deals, such as the recent Golden State. We’ve also see a cat bond structure cover lottery winning risks, a third-party modelling firm emerge for energy and oil spill risks and new platforms seek to reduce the complexity of issuance. Not bad for a market which has seen the most losses in its history and grappled to come to terms with model changes and catastrophes over the course of this year. We hope to see an even greater amount of incremental innovation in the ILS and cat bond markets during 2012.

You can download the full sigma report titled “Product innovation in non-life insurance: where little ‘i’ meets big ‘I’” from the Swiss Re website.