Insurance vs other hedging tools

 
 
 

Insurance anyone? For once, you may want what is on offer…

Do you know anyone who willingly buys insurance – either for their home or business? Didn’t think so. Insurance has a long history of being sold, rather than bought, and its relevance – especially to companies – seems to be going downhill year by year.

The types of risks that worry companies the most have continuously evolved over the past 20 years, moving from the tangible sphere to the intangible. For many reasons, insurance – as a risk mitigation tool – has not followed suit, leaving 9 out 10 top global risks wholly or partially uninsurable in 2019 according to Aon’s latest Global Risk Management Survey. In this blog, we put our lens on #7 - commodity price risk. Comparing established hedging tools to a recent innovation in insurance - parametric products, we give our verdict on the pros and cons of each.

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Pooling risk in new ways

Unprecedented access to data, computational power and new technologies like Artificial Intelligence (AI) are changing the way that risk can be identified, evaluated and priced. Comfortable with the status quo, traditional insurers may not be the first to jump on this bandwagon, but there are swathes of entrepreneurial InsurTech firms who are looking to fill the gap – and transform the bad rep of insurance in the process.

Market risk, e.g. price volatility in commodities such as metals and oil, has long been an area of reticence for the traditional insurance industry. This is because market risk, which is systemic in nature, doesn’t lend itself well to established methods for risk pooling. An insurer who covers 100 homeowners against their properties burning down has made money from the fact that only very rarely are all 100 houses destroyed at the same time. Say instead that the insurer would take on board 100 equipment manufacturers, covering them against price spikes in aluminium. With commodity price volatility growing since the last financial crisis, making it #7 among the global top-10 risks, the insurer could very well face 100 unhappy claimants – not just once in a while, but every year. 

Combined, data and AI techniques allow for risks to be pooled in new ways – across different commodities, time horizons and price movements (up or down) rather than across individual businesses. A new world of risk mitigation is dawning.

Parametric insurance – the (somewhat) new kid on the block

Working hand-in-hand with advances in data access and technology, parametric insurance – a relatively new form of risk mitigation – enables a number of age-old protection gaps to be filled in a cost-efficient, time-efficient and objective way.

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Rather than waiting for an actual loss to be sustained, reported and investigated before any compensation is paid out, the cover of parametric insurance is triggered when a pre-specified event occurs – as confirmed by independent, third-party data. 

Examples of such parametric products are covers for damage caused by hurricanes (e g StormPeace) and flooding (e g FloodFlash), as objectively measured by local wind speed, rainfall or flood levels. In a commodity price risk context, ChAI’s equipment manufacturers could receive compensation for an increase in purchasing costs when the price of aluminium moves above a certain, pre-agreed threshold as reported daily by e.g. the London Metals Exchange. As there is no need to inspect the loss, payments can be more or less instantaneous. 

Addressing commodity price risk with insurance – is it any good?

So, parametric insurance is the newest tool available for companies to do something about commodity price risk. This is excellent news, in particular for SMEs who have long been excluded for cost and complexity reasons from the hedging instruments available to their larger peers. But how does it stack up against other, more established, risk mitigation methods?

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In practice, forward, future and option contracts are unavailable to SMEs as they are prohibitively expensive and administratively heavy, in addition to requiring technical trading knowledge. Time horizons for fixed-price supply contracts are becoming shorter, and prices may only be fixed up to a certain level – thus removing all opportunity of benefiting from good market conditions, while not removing all downside risk. In addition, fixed-price supply contracts carry high spot price mark-ups. 

No wonder many SMEs so far have chosen to do nothing in order to mitigate their commodity price risk – therefore suffering from equally volatile cash flows and P&Ls, which has seriously limited their ability to plan for the future. Thanks to advances in data access and technology, insurance is now in a position to change that frustrating status quo – offering a relatively simple, affordable and accessible way to mitigate commodity price risk. Time for insurance to lose some of that bad rep.

ChAI exists to remove the pain of commodity price volatility for our clients. Offering parametric insurance to SMEs is just one way for us to do this. If you have struggled to find an affordable and easy solution for your risk mitigation needs in the past, then we are here to help you achieve a better, less volatile future for your business.

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