Marcus Schmalbach of RYSKEX outlines how a captive can become a profit centre with parametric insurance.
In the soon to be published whitepaper Heartbeat in the Fog: Parametric Insurance of Intangible Assets, John Donald of Axis Capital uses an interesting analogy to explain recent developments in the Insurance Linked Securities (ILS) market. Examining the balance sheets of the S&P 500, some 83% of their value now stems from intangible assets, up from only 20% or so 40 years ago. These intangible assets – a heterogeneous collection of items such as service contracts, intellectual property, goodwill, software, trademarks, data, rights of use and other non-physical goods – are largely uninsured. Unlike property or machinery, they are hard to classify and even harder to evaluate. This is the fog.
Traditional insurance is based on the concept of indemnity. There must be a demonstrable and calculable loss that can then be used to justify a payment in compensation for that amount. The challenge is that in the hazy fog of intangibles, financial values, and indeed damage, is hard to pin down. This is where parametric insurance comes in. The beauty of parametric insurance is that it is free from the concept of demonstrable asset damage, so you don’t need to figure out what a particular asset is worth. Parametric insurance is as simple as an if/then statement: if this, then pay that. All that is needed is a trigger and a payout mechanism. This is the heartbeat in the fog.
Global capital markets are very familiar with parametric triggers since they are what drives derivative contracts, like stock and bond options. The global market for derivatives has a notional principal value of $700trn, which dwarfs reinsurance markets in terms of capacity. The Aon Reinsurance report 2020 estimates the global pool of reinsurer capital is only $532bn. The capital markets, with much deeper pockets and a long familiarity with the underlying concepts, are a natural fit for parametric insurance products. This reality explains the growth in ILS. In 2019, some $11bn of ILS risk capital was issued which, according to Artemis, brings the total figure to $40bn.
The good news for captives is that the growing ILS market offers the potential for them to become profit centres opposed to cost centres. Figure 1 shows how this might happen in terms of information symmetries. The fundamental lynchpin of pricing risk comes down to knowledge: the more you know, the more accurately you can price the risk. Between a captive and its parent company, we can assume a high degree of information symmetry. After all, they are part of the same entity, so it is unlikely that there are any skeletons in the closet yet to be discovered. The parent pays a premium to the captive. If the captive can then place this risk elsewhere at a lower premium, it will become a corporate profit centre.
In the traditional captive model, risk is placed through underwriters and reinsurers. The premiums are higher because of the information asymmetry, along with the administrative costs. But if the risk is bundled in an ILS structure and placed in the global capital markets, the costs can be dramatically reduced. Parametric insurance eliminates the arduous and lengthy claims process and reduces broker and admin fees. Some models suggest that the potential cost savings through parametric insurance can be as high as 45%. With cost savings of this magnitude, lower premiums are clearly possible, and may be low enough to turn the captive into a profit centre.
One other possibility worth considering is risk pooling. Pooling risk tends to reduce volatility due to the law of large numbers, which in turn should lead to lower premiums. This, of course, is the core principle of reinsurance. But if captives in the same industry were to pool together to form a mutual risk captive, they would gain this advantage themselves. Being in the same industry, there would be less information asymmetry. This would be a return to the earliest days of insurance in Lloyds coffee shop. To paraphrase the poet T.S. Elliot, sometimes at the end of all our exploration we end up at the place we first started, but know that place for the first time.
Written by Dr Marcus Schmalbach, founder and CEO of RYSKEX GmbH. He has a longstanding experience in risk and captive management in various industries. Before the founding of RYSKEX, he was head of German MBA programme. He is still working as a visiting professor on Innovation and Risk Management matters and also academic head of BlockART institute with a research focus on GIG companies, parametric solutions, Blockchain Technology and the impact of AI on the captive value chain.