California Climate Insurance Working Group Sizes Up Parametric Solutions
Executive Summary
California’s Commissioner of Insurance convened a Working Group to explore the role innovative insurance solutions may be able to play in helping communities and families manage the risk of climate change. One of the Working Group’s recommendations is to promote parametric insurance. While traditional insurance indemnifies the policyholder for actual loss, parametric insurance pays out a pre-set amount if a disaster such as a flood, wildfire or heat wave exceeds specified parameters.
There is just one hitch: Parametric insurance is not insurance. After the 2008 financial crisis, Congress enacted Dodd-Frank to, among other things, sweep parametric and other event contracts under the jurisdiction of the Commodities Futures Exchange Commission (CFTC). The Working Group is right to highlight the potential for parametric solutions to become an effective risk management tool, but it must invite the CFTC to join in the discussion if it hopes to move its recommendations toward reality.
California Climate Insurance Working Group Recommends Parametric Insurance Products
CA Ins. Code § 12922.5 requires California’s Commissioner of Insurance to “convene a working group to identify, assess, and recommend risk transfer market mechanisms that promote investment in natural infrastructure to reduce the risks of climate change related to catastrophic events.” The legislature believes “[i]nnovative insurance and reinsurance businesses may provide opportunities to reduce the exposure of local communities and homeowners to these events.”[1]
On July 21, 2021, this Working Group recommended a “first-of-its-kind climate insurance” for “reducing damage and improving recovery following a wildfire, extreme heat wave, or flood.”[2] Several of the Working Group’s recommendations favored an “expanded use of parametric insurance.”[3] The Working Group described parametric insurance by comparing it to traditional insurance:[4]
Typical property insurance in the United States is what is referred to as indemnity coverage; this means it reimburses the insured for the amount of damage sustained. For instance, if you have homeowners insurance and a tree falls on your house, your insurance company will send an insurance adjuster to estimate the cost of repairs and that will be the amount of funds (subject to deductibles and coverage caps) that you receive. Parametric insurance, in contrast, is event based and pays a set amount of money to the insured based on a pre-agreed and objective measure of the disaster itself — called the trigger. For instance, a parametric insurance product for hurricanes might pay a certain amount when a given category of storm crosses within so many miles of the insured’s home. This could provide cost-effective funding for preparation for an impending storm. The benefits of parametric insurance for disasters are that they can provide funds much faster and the payouts can be used flexibly for any needed and unanticipated expenditures, deductibles, or lost revenue, which are typically insurance gaps. The downside is that the actual payout may be more or less than the damages sustained.
To summarize the Working Group’s paper, traditional property insurance indemnifies the policyholder, meaning “it reimburses the insured for the amount of damage sustained.” In contrast, parametric insurance “pays a set amount of money to the insured based on a pre-agreed and objective measure of the disaster itself.” As a result, parametric insurance payout “may be more or less than the damages sustained.”
Paramedic Insurance is Not Insurance under California Law
Under California law, “insurance” means traditional insurance through which the policyholder is reimbursed for an actual loss:[5]
Insurance is a contract whereby one undertakes to indemnify another against loss, damage, or liability arising from a contingent or unknown event.
California’s statutory description of the recognized classes of insurance carry forward the requirement that contracts regulated as insurance must promise to indemnify a loss. For example, the California Insurance Code defines fire insurance as “[i]nsurance against loss by fire, lightning, windstorm, tornado, or earthquake”.[6] Even miscellaneous insurance, the broadest class of insurance under California law, is defined as “insurance against loss from damage done.”[7]
Similarly, California law embeds the concept of indemnity within the statutory requirement that a policyholder must possess an insurable interest. An insurable interest is defined as “the measure of an insurable interest in property is the extent to which the insured might be damnified by loss or injury thereof.”[8]
In short, “insurance” is traditional indemnity insurance that reimburses the policyholder for an actual loss incurred. Parametric insurance, which pays a fixed sum based on the parameters of a defined triggering event, may be marketed as insurance but falls outside its legal or regulatory scope.
Parametric Insurance is a Swap under the Jurisdiction of the CFTC
As explained in our paper The Regulatory Environment for Parametric Insurance (July 2021), Dodd-Frank conferred authority upon the Commodities Futures Exchange Commission (CFTC) to regulate “swaps”. A swap is:[9]
Any agreement, contract, or transaction … that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.
Recognizing that this sweeping definition encompassed traditional (indemnity) insurance products, the CFTC created a safe harbor exemption for a contract that meets both a product test and a provider test.[10] One of the conditions of the product test is that the contract “[r]equires [a] loss to occur and to be proved, and that any payment or indemnification therefor be limited to the value of the insurable interest.”[11] One of the conditions of the provider test is that the contract “is regulated as insurance under applicable State law or the laws of the United States.”[12]
Parametric insurance falls short of both of conditions for exemption from the CFTC’s jurisdiction.
First, parametric insurance does not pay out based on the amount of loss. Instead, a parametric contract pays out based on the parameters of the triggering event. As the Working Group put it, parametric insurance “pays a set amount of money to the insured based on a pre-agreed and objective measure of the disaster itself.” While this description fits squarely within Dodd-Frank’s definition of a swap (i.e., a contract providing “payment … that is dependent on the occurrence, nonoccurrence, or the extent of occurrence of an event”), it does not satisfy the CFTC’s product test for the insurance exemption (i.e., a contract requiring a “loss to occur and be proved, and that any payment … therefore be limited to the value of the insurable interest”).
Second, parametric insurance is not regulated as insurance under California law. A contract is regulated as insurance under California law only if that contract promises to “indemnify another against loss”. As the Working Group describes parametric insurance, the contract beneficiary receives “a set amount of money” that “may be more or less than the damages sustained.” A contract providing a pre-determined fixed payout regardless of the actual amount of loss is difficult to reconcile with the California Supreme Court’s understanding of “indemnification” as an “obligation … to make good a loss or damage another party has incurred.”
The California legislature could not simply change the law to broaden the Commissioner of Insurance’s regulatory authority to include parametric insurance. Dodd-Frank foreclosed that possibility by providing that a “swap shall not be considered to be insurance [and] may not be regulated as an insurance contract under the law of any State.”[13]
In other words, Congress and the CFTC are empowered to draw the line between a swap and insurance — not the individual states. They have done so and parametric insurance falls squarely within the jurisdiction of the CFTC.
The Future of Parametric Insurance Remains Promising
Despite its report’s jurisdictional mix-up, the Working Group’s enthusiasm for parametric solutions is far from misplaced. As the Working Group notes, parametric products could be designed to “provide cost-effective funding … much faster [that] can be used flexibly for any needed and unanticipated expenditures, deductibles, or lost revenue, which are typically insurance gaps.” The Working Group simply needs to shift the lens through which it views these products from state-regulated insurance to CFTC regulated swaps.
Insurance companies are eligible to design and market parametric products if appropriately registered with the CFTC. Indeed, consumers would benefit from the broader range of product offerings and deeper price competition if both insurance company and non-insurance company providers participate in the parametric contract market. CFTC regulation also requires specific training and oversight of staff engaged in selling swaps, tailored consumer protections, and appropriate anti-money laundering controls — each of which would enhance current parametric insurance offerings.
CFTC jurisdiction also remedies some of the defects apparent in the nascent parametric insurance market including generous sales commissions, low return of value to customers, and high overall expenses.
Parametric insurance products typically carry very high sales commissions. According to the NAIC’s compilation of property and casualty insurance filings, sales commissions average about 11.5% of direct written premium across all lines of insurance. It is not unusual for commissions paid to intermediaries of parametric insurance to reach 40%. Outside of insurance, retail consumers have become accustomed to comparatively transparent and heavily discounted commissions for financial services often amounting to a fraction of a percent of the value of the transaction. The parametric market may never get to Robinhood’s commission levels, but it should easily land a lot closer than it is today.
Parametric insurers typically return little of the premium they collect back to policyholders. According to the NAIC’s compilation of property and casualty insurance filings, the average loss ratio across all lines of insurance is around 71%. That means 71¢ of every $1 of premium is returned to policyholders in the form of claims payments and claim administration costs. In contrast, it is not uncommon to find expected loss ratios for parametric insurance products in the range of 30%. That is, only 30¢ out of every paramedic premium dollar is expected to help a consumer in need. Some of the worst rated charities spend more of each dollar delivering on its core mission.
Parametric insurance products are typically heavily laden with expense. According to the NAIC’s compilation of property and casualty insurance filings, the average expense ratio across all lines of insurance is around 27%. That means 27¢ of every premium dollar goes to pay non-claims expenses such as distribution costs, overhead expenses, and other charges. It is not uncommon to find parametric products with planned expense ratios exceeding 60%. So, for each $1 that is paid out to a policyholder for a parametric insurance claim, another $2 is eaten up by sales charges, administrative expenses, salaries, and bonuses. Far from the “cost-effective” solution envisioned by the working group, current parametric solutions appear particularly inefficient.
The Working Group noted that “[p]arametric earthquake coverage is currently being explored in California.” The Working Group members, including the Insurance Commissioner, can be forgiven for not fully understanding the underlying economics of this exploratory market. Each of the three parametric earthquake insurance products available to California’s retail consumers are offered through an insurance company that does not hold a license to do business in California (known as “non-admitted” insurers).
As the California Department of Insurance explains, non-admitted insurers are not required to make any filings with the California Department of Insurance (including the products they sell to California consumers and the rates they charge them).[14] When an insurance broker offers a product from a non-admitted insurer, the California legislature requires the broker to obtain a signed disclosure from the buyer in all capital letters and 16-point font including warnings that:
- The insurer is not subject to California financial solvency regulation and enforcement; and
- The policyholder is not protected by the California’s insurance guarantee funds in the event of insurer insolvency.
California’s parametric insurance consumers have been left to fend for themselves in the very deepest and most opaque end of the insurance market. That is an inadequate regulatory foundation on which to build a solution the Working Group hopes will serve the most vulnerable communities. The CFTC and the Consumer Financial Protection Bureau (CFPB), its sister agency, have the regulatory tools to drive the transparency, soundness, and consumer protection that would help parametric solutions realize the potential identified by the Working Group.
[1] Senate Bill №30 (Sept. 2018).
[2] Recovery from climate change-intensified natural disasters can be faster, more equitable through new ‘climate insurance’ strategies, experts find, California Department of Insurance Press Release (July 22, 2021).
[3] California Climate Change Working Group Paper at page 12. See Cross-Cutting Recommendations 14; Extreme Heat Recommendation 5, Extreme Heat Recommendation 7
[4] California Climate Change Working Group Paper at page 43.
[5] CA Ins. Code § 22. The California Supreme Court has defined indemnification as “the obligation resting on one party to make good a loss or damage another party has incurred.” Rossmoor Sanitation, Inc. v. Pylon, Inc., 13 Cal.3d 622, 628 (1975).
[6] CA Ins. Code § 102.
[7] CA Ins. Code § 120.
[8] CA Ins. Code § 284.
[9] 7 U.S.C. § 1a(47)(A)(ii).
[10] 17 CFR § 1.3 (Swap)(4).
[11] 17 CFR § 1.3 (Swap)(4)(i)(A)(2).
[12] 17 CFR § 1.3 (Swap)(4)(i)(B)(1)(ii).
[13] 7 U.S.C. § 16(h).
[14] None of the three insurance companies appear on California’s List of Approved Surplus Lines Insurers.
