Efforts in top gear for index-based insurance

The Financial Inclusion Working Group (FIWG) of the International Association of Insurance Supervisors (IAIS) has – through a drafting group developed a draft Issues Paper on Index-based Insurances, expecting comments and contributions by 29 January 2018.

Index based insurance is a relatively new, innovative, and increasingly popular approach to insurance provision. The product involves contracts where a claim is defined with reference to a pre-determined index (sometimes also referred to as parametric insurance).

As index-based insurance is increasingly looked at as a means to manage weather and catastrophic events, support food security and enhance access to insurance, this Issues Paper provides background on this product, describes practices and actual examples and identifies related regulatory and supervisory issues and challenges.

According to the Committee, the document focuses on the insurances usually directed at weather related or natural catastrophe event risks. These insurances sometimes focus on agriculture and other times on protection from natural catastrophes. There have also been cases where the index is focused on other measures, for example intended as a proxy to risks such as political instability or economic adversity. Similar products may also be targeted at catastrophic health or life insurance covers such as pandemics. The paper does not exclude those innovations from the scope. However, the paper does not address products where the index is solely a function of capital markets, asset prices or other economic measures, or where payouts are determined by the value of underlying assets in an investment portfolio, nor does it address products that are based on an index related to mortality rates particularly directed at long term longevity risk.

Often, the index seeks to reflect losses arising from weather and catastrophic events, attracted by the opportunity to avoid the cost and administrative delay from traditional services of insurance claims assessors. These features provide the promise of significantly reducing underwriting and claim assessment costs. They also allow for the claims settlement process to be quicker and more objective. The combination of these elements has encouraged efforts to reduce the barriers to providing effective and affordable insurance, particularly for lower income groups that tend to be more vulnerable to such events. Improved access to insurance can directly and indirectly enhance livelihoods, reduce poverty and create opportunities for economic advancement. Regarding agriculture in particular, the provision of effective insurance is also seen as a way to facilitate a more productive agricultural sector.

In many respects, index based insurance programs directed at low income clients do face many of the same challenges as other efforts to advance inclusive insurance. Not all challenges are a consequence of the index based insurance context. These challenges could include the need to overcome cost barriers in service delivery, ensure rapid claim payment, and have customer service delivery that takes account of the possibility that clients have limited financial literacy.

Other issues arise that are peculiar to index based products or specific to the context in which they operate. Many of the current programs are in a pilot stage.

The context may mean that pilot phases may take longer to achieve outcomes and it may take longer for the initiative to become sustainable. Pilotings of agricultural products are constrained, for example, by the timing and frequency of agricultural seasons.

The index itself needs to be well structured and functional. Like other microinsurance programs, an index based insurance scheme may depend on having a very large number of clients so as to maintain low cost premiums but the specific nature of the risk index might make it more difficult to broaden the program. In agricultural insurance, it is a competing challenge to orient the index toward consumers who are located in similar agro-climatic conditions to better reflect potential risk exposures. In fact, the more broadly an index is applied to increase the potential number of covered clients, the more challenging it is to reduce the risk that the index will not be sufficiently responsive to reflect the circumstances of local clients (increasing basis risk).