Real estate companies with assets in catastrophe-prone areas or certain challenging occupancies are struggling to find adequate (or any) insurance coverage for these risks. Insurers have, in recent years, pulled out of these markets altogether, leaving less competition and prohibitive premiums.

Fortunately, creative solutions like parametric insurance and captives offer a buffer from the volatile marketplace, potentially saving money and offering more complete protection where traditional insurance falls short. I employ the term “strategic risk transfer” as an alternative philosophy to pure insurance buying, leveraging the standard insurance marketplace where it’s cost effective to do so for backstop capacity and not where that policy premium becomes more burdensome than the losses you seek to insure against. This is the foundation of a more bespoke risk-management program.

What is Parametric Insurance?

Parametric insurance offers coverage based on predefined parameters rather than actual asset loss. For example, for buildings in Florida susceptible to windstorms, coverage might be triggered by sustained wind speeds as recorded by the National Weather Service. California earthquake coverage would be triggered by peak ground acceleration rather than a shake loss at an insured building. Once that triggering event happens, the insured will be paid out based on total economic loss, beyond that which might be covered under a standard property policy. This could include, for example, prolonged loss of rental income in damaged units.

One of the standout benefits of parametric insurance is the speed of payouts. Traditional insurance claims can be delayed due to the extensive process of damage assessment and claims adjustment, especially following large-scale disasters. Because parametric payouts do not require the same kind of claim filings, this approach bypasses the lengthy and often contentious claims adjustment process, providing immediate payouts once the parameters are met. The insured gets the money faster, allowing them to address damage and resume operations quickly. This immediate liquidity is crucial in competitive markets where rebuilding swiftly can make a significant difference. Not to mention parametric insurance is first-dollar, without any deductibles.

What are Captives?

Captives are another innovative, strategic tool in risk management wherein the insurance company is owned by the insured. Though there are many types of captives, I often compare a traditional single-parent captive to an HSA for health insurance. It’s not “use it or lose it,” as the money continues to accrue in the absence of insured losses. This setup allows businesses to retain and manage their own risk, providing greater control over coverage and costs. Captives offer several advantages:

• Market insulation: By creating a captive, businesses can accrue capital over the long term, insulating themselves from insurance market volatility.

• Cost efficiency: Instead of paying premiums to third-party insurers, businesses retain this capital within their captive, potentially earning investment returns.

• Customized coverage: Captives allow for coverage of losses which may not be covered by traditional insurance, such as water damage or kitchen fires.

In practical terms, a captive can also take on the initial layer of risk, relegating traditional insurance policies to cheaper excess capacity. Traditional insurance works well for unpredictable, high-severity events. However, it can become inefficient for high-frequency, low-severity losses that are almost certain to occur for businesses at scale, which is where a captive can help. By retaining these predictable risks within a captive, businesses can save on premiums and manage funds more efficiently. Insurance works best when there is merely a risk of loss. When low severity claims become a near certainty based on underwritten loss performance, you are effectively paying for an expense manager along with protecting your business from the potentially catastrophic events that could jeopardize the ongoing viability of the company.

Consider a scenario where a company has been purchasing earthquake insurance for decades without a claim. By shifting these premiums into a captive, the company retains the funds, which can generate returns and be used to cover potential future losses. This strategic approach transforms insurance from a pure expense into a financial asset. As the captive grows over time, it can cover more substantial risks, further reducing dependency on the volatile open market. Backstop capacity can then be purchased at a fraction of the cost for more capacity.

Who is Best Suited for These Alternative Insurance Structures?

Every client has unique exposures and risk philosophies. They've also got their own ownership structures, third-party capital, and investors to take into consideration. Part of my job is to bring as many ideas to the table as possible and educate my clients so they can make an informed decision. 

Some clients don’t want any uncertainty in terms of what their risk will cost. During the course of the year, they’re willing to cut a check to the carrier for a guaranteed cost structure so that they stay within a certain budget. I have other clients that want the most sophisticated position possible and are willing to invest in understanding their options. They also have an appetite for taking on some risk. I often advise these types of clients to consider parametric insurance if they’re spending a lot on catastrophic coverage and where the traditional insurance may be lacking or insufficiently flexible to address their needs. Captives can be useful for clients who have a substantial premium on an annual basis and either have an ownership or operational structure where a captive makes sense in the long term. Forming a captive is not a short-term fix but, rather, a long-term shift in risk philosophy and buying habits. Parametric and captives are not mutually exclusive, and clients may choose to employ both solutions. 

While there is added complexity, it typically pays off. The majority of the time, year after year, clients with these complementary solutions will end up far better off than just paying a carrier outright to assume all of their risk.

Taking a Partnership Approach for Strategic Risk Transfer

Implementing parametric insurance and captives requires a collaborative effort between the broker and the client. Modern risk management is not a one-size-fits-all solution but, rather, a bespoke engagement that considers the unique exposures, operational structures, and strategic goals of each client.