Beyond parametric: Insuring the IFRC Disaster Response Emergency Fund
Author: Conor Meenan & Cristina Stefan
Photograph: Shutterstock
The launch of a new risk transfer instrument by the International Federation of the Red Cross and Red Crescent Societies (IFRC) marks an important milestone for risk transfer in humanitarian contexts. Why is this insurance policy notable? Quite simply, it’s not parametric.
Parametric indices are often seen as the preferred way to develop risk transfer instruments that align with the emergency costs of natural hazards. Parametric triggers have proven vital in extending the role of insurance-like mechanisms into situations where the costs of crises are difficult and time consuming to assess in real time.
In the case of IFRC, an insurance policy was developed to provide financial protection for the Disaster Response Emergency Fund (DREF) in extreme years, based on the accumulated reported allocations from the fund rather than using a parametric index to trigger for insurance payouts.
In practice, this means that DREF monitors and reports the allocations it makes to National Societies, the local IFRC organisations who deliver the response, throughout the year. If the allocations exceed a pre-set threshold – the attachment level of the risk transfer policy – then the insurance steps in to cover allocations above this threshold up to a certain limit (that resets annually). This type of structure is standard in the commercial reinsurance markets, but its application in a humanitarian context is novel.
This blog explores two questions – why does the new risk transfer instrument use reported allocation information rather than a parametric index to trigger payouts, and how was it possible to develop risk transfer for a humanitarian organisation without an index?
What is parametric insurance?
Parametric indices are the default trigger option in risk transfer instruments protecting against the costs of natural hazards. Parametric indices use event observation or forecast data to approximate the severity and timing of a crisis, and trigger payouts to finance emergency response costs. When a pre-agreed trigger threshold is reached, such as specific a wind speed in the case of a hurricane or sustained flood depth at an urban location, funds can be activated quickly based on objective and verifiable criteria. When parametric triggers are designed well, they can provide fast and transparent payouts to policyholders.
There are various advantages to using indices, but a key aspect is that they provide clarity about the justification for a payout in situations where the scale of a funding response is otherwise unclear. This clarity is critical for risk transfer instruments in the humanitarian sector for two reasons.
Firstly, humanitarian impacts on affected populations are difficult to measure objectively in real time – as are the humanitarian responses and associated funding needs. Indices allow insurance payouts to be made based on timely event information that is reported by a trusted third party. This clarity is useful from an operational perspective, as it creates a space for responders to make credible plans that align with funding. It is also valuable in risk transfer contracts so that there is no room for disagreement about the size of an insurance payout, as the payout links directly to an objective calculation that has been agreed ahead of time.
Secondly, the design of risk transfer instruments relies on insurers being able to measure the size and likelihood of potential future payouts. Estimates of expected future claims are used to decide the premium for the insurance policy. Historical humanitarian response cost information is usually unavailable or insufficient to provide a good view of future costs. Historical and modelled information about hazards such as ground shaking due to earthquakes or rainfall at a particular location is more available and reliable, and so parametric indices based on these observable hazard measurements are a useful proxy for the humanitarian impacts and response costs. Anchoring insurance payouts on observable measurements makes it easier to model future payouts, which allows the insurance policy to be priced.
So, parametric indices have many operational benefits, but they are also often necessary to structure and price private markets risk transfer instruments, especially when crisis-related costs are difficult to measure objectively based on historical events or in real time.
The trigger used in the DREF risk transfer policy is not parametric, so why was the parametric option not taken, and how was it possible to structure and price a non-parametric risk transfer instrument?
Three reasons DREF isn’t based on a parametric index
The IFRC DREF is a pre-financed pool of money used by the organisation since 1979 to provide fast funding for local responders when humanitarian crises first emerge. The money from DREF is not intended to cover the full costs of emergency response, but to provide critical funding that can be used in advance of larger funds being generated from appeals and other sources and provide financial support for small and medium responses which may not be funded by appeals.
The DREF has three characteristics which mean parametric approaches are less appropriate and which mean risk transfer can be structured based on monitoring of allocations:
Global and multi-crisis scope. The DREF supports funding for many types of crises globally, including natural hazards and other complex crises. Parametric indices are useful in many situations, but it would be technically and practically challenging to develop a single parametric trigger that capture accurately all the natural hazard events that DREF responds to at a global scale.
Operating procedures and allocation rules. Allocations from DREF are made according to rules set out in operating guidelines. National Societies class crises according to initial assessments of the numbers of people affected, and this information is used to determine the allocation amount, which is limited by ceilings according to the classification of the event. The allocation ceilings mean that future allocations from DREF are not unlimited, and the rules-based processes mean that allocations will happen according to processes that can be understood and modelled by insurers.
Publicly available historical information. The DREF fund has been operating according to these allocation rules for years, and information about previous allocations is reported publicly by IFRC. This historical record provides information that can be used to anticipate the funding requirements for DREF in future years.
These characteristics also provide a sufficient level of clarity and trust that have made it possible to develop together with the private markets a risk transfer instrument that relies on reporting of actual allocations rather than a parametric index.
The risk transfer instrument that has been developed provides multiyear cover for natural hazards at a global scale. It integrates seamlessly with the existing DREF fund so that the insurance coverage matches the funding needs of DREF towards allocations to National Societies. The insurance works with existing operating processes so that from the perspective of National Societies there is no difference to how the DREF is used to provide fast funding.
A broader toolkit for insuring increasingly complex crises
Parametric indices are powerful tools, and they will continue to be the best and often only option in many cases for organisations seeking to use risk transfer to pay for emergency response costs. The launch of this non-parametric risk transfer policy adds another option to the risk financing toolkit for humanitarian organisations preparing for a world of increased risk and increasing humanitarian funding needs.
This risk transfer policy is a first step towards broadening the role of risk transfer beyond parametric indices. While it may not generate the same level of excitement as parametric insurance, which leverages technological advancements and modelling, its design and implementation showcase innovative features that set it apart.
Firstly, the DREF already had a structured and sophisticated pre-arranged approach to allocating response funds – the risk transfer policy builds on these existing processes and doesn’t require the DREF or National Programs to change how the DREF is used.
Moreover, the risk transfer instrument covers all-natural hazard-related allocations at a global level. The insurance coverage is agnostic about where crises happen or whether allocations are for floods or fires. This approach lays the groundwork for risk transfer covering complex risks at scale, where parametric approaches might struggle. Future variations could even extend to covering non-natural hazard-related costs, provided that allocations happen according to the agreed operating and allocation processes.
Finally, the policy highlights the value of public accounting and reporting of crisis-related cost information. The structured allocation processes and historical data provided an essential platform for the insurance industry partners to gain the insight and trust necessary to offer a policy on a non-parametric basis.
As with any new approach, there will be important lessons over the coming years as the DREF uses this risk transfer policy. In a world where crises are becoming ever more complex and costly, the launch of the new risk instrument is an important milestone which opens the door for risk transfer to play a broader and more flexible role in supporting some of these future humanitarian costs.
The DREF insurance was developed in close collaboration between IFRC teams, Aon, insurance markets, and with advisory support from the Centre for Disaster Protection. It is intended to provide an additional layer of financial protection to reduce the possibility of the DREF running out of funds to support local responses.