In this article from the 2023 Power Market Review we take a look at how innovative parametric solutions are a valuable tool for managing and transferring risk
A reminder - what are parametric solutions?
Parametric (or index-based) solutions are far from new. Previously, they were been seldom used, but the concept has been applied as an alternative to insurance for decades. Although not necessarily a derivative, their function is based on the same way that a derivative operates. An index is selected that best represents the risk to be hedged, and if the value of that index moves to a point above (or below) a selected threshold at an agreed point in time, then a payment becomes due according to an agreed pay-out formula. It's as simple as that.
Viewing parametric coverage as a means of addressing differing needs from traditional coverages may ultimately offer a broader perspective.
Simplicity is, in fact, probably the greatest benefit of the parametric contract: there is no need for any loss adjustment, and indeed, no provision is made for the evaluation of the actual loss in any way. As a result, the speed of contract settlement can be reduced to a practical minimum, usually constrained by the time it takes to report the value of the index, which is almost always tasked to a trusted third-party provider. This may only be a matter of hours in the case of some automated systems or weeks for more manual setups, especially those in which careful verification of potentially anomalous readings is required.
But this very simplicity potentially masks a pitfall: basis risk, which is the risk that the chosen index does not reflect the underlying physical or financial loss very well. Of course, the worst instance of this is when a major loss occurs but little or no payment falls due under the terms of the contract. The reverse is possible, and a payment may fall due under the contract, yet little or no loss has actually been incurred. Whilst the latter may seem like a windfall - albeit one for which a premium was properly payable - these mismatches represent an unacceptable lack of precision for the original risk management purpose. Indeed, such insurances in some jurisdictions require an element of proof of loss for these contracts to be recognised as true contracts of insurance. In these cases, 'proof' may often be adequately satisfied by self-certification that 'a' loss has occurred or, perhaps, a loss (financial impact from all sources) that is at least as large as the pay-out. To require a high standard of loss evaluation would undermine the key benefit of a parametric contract.
Why use parametric coverage for power risks?
A facetious answer might well be: why not? The idea of a transparent policy and speedy pay-outs is attractive in and of itself. Furthermore, a decision need not be all or nothing, as parametric solutions may be considered not as an alternative to indemnity-based insurance but as a complement, or perhaps as a supplement to the existing conventional insurance programme.
WTW views parametric components as sitting within an existing insurance programme rather than somehow displacing tried-and-tested coverages.
Indeed, viewing parametric coverage as a means of addressing differing needs from traditional coverage may ultimately offer a broader perspective on risk management than covering the costs of physical damage, business interruption or liabilities. In particular, the prospect of rapid liquidity in the immediate period following an event, where funds can be deployed (as is the case with a parametric pay-out) for whatever purpose is most pressing, can confer genuine value.
This may especially be the case in the aftermath of a severe natural catastrophe, in which the physical and financial consequences may be quite unpredictable and unexpected. A rapid infusion of cash to respond, mobilise, repair, and assist could literally be a matter of life or death.
When extreme events impact the physical assets of an installation, it may be tempting to consider only the issue of whether sufficient insurance has been taken out to cover the physical and financial consequential losses to the impacted assets. But what about the immediate and subsequent wellbeing of staff and their families? Timely financial support and intervention for members of staff whose families may have been displaced, or worse, can provide an economic lifeline. Such support is good for the individuals and good for individuals and for the company in terms of its resilience and from an ESG perspective.
Insurance where cover may be unavailable
It has been pointed out that parametric insurance solutions may provide effective and flexible enhancements to existing, traditional insurances that are routinely taken out by power and energy businesses - where they can. But what about circumstances in which the existing insurance offerings leave gaps in the risk register?
Parametric solutions may be able to offer protection where none is otherwise available in any conventional form. There's a straightforward reason for this - and it's not that parametric underwriters somehow have special powers that others do not. It comes down to the fact that a parametric policy seeks to convert the intricacies and challenges of an indemnity-style policy into an indexed metric. Underwriting the index is a relatively simpler matter of analytics, whereas underwriting a complex risk - with all its specifics and uncertainties - requires expertise and experience.
An industry example of this might be the circumstance in which traditional natural catastrophe capacity may be all but exhausted, but re-thinking the risk in terms of a parametric structure in the relevant region or catchment may offer a solution.
In catastrophe-exposed areas - say for an earthquake or cyclone - it is likely that such events will cause collateral loss, not just to generation assets but also on a wider area basis, including access and associated infrastructure. A well-structured pay-out from a parametric programme may therefore provide a much-needed contribution to extra expenses resulting from the event and non-damage business interruption (NDBI).
Similar benefits have been achieved by implementing parametric cyclone cover to protect against the extra expense incurred by the occurrence - or even the threat of the occurrence - of a powerful cyclone. As assets may be located remotely with limited access, the need to take early preventative action to evacuate personnel can become critical and costly. A parametric cyclone contract can cover this obligation in a way that a conventional policy cannot and may help to reduce provisioning costs for the project as a whole.
Protection against low levels natural resource
Insurance solutions against physical loss or damage are well developed for the power industry. Such contracts are highly effective and form the mainstay of traditional insurance protection for the sector. But what about the situation when there is no insurable event - nothing happens - and no power is generated? This eventuality is well illustrated in the renewable sector in which low wind, low solar and low hydro resource results in low (even no) energy production.
For as much as a parametric may provide valuable coverage in the event of too much of a given element, it is equally applicable in the event of there being too little. The approach and methodology is entirely the same, if turned on its head.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.