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HOW DO PARAMETRIC DERIVATIVES AND INSURANCE PRODUCTS DIFFER?
Donors ended up giving over USD 7 billion in aid for Ebola response and recovery. Since then, the World Bank has developed thePandemicEmergencyFinancingFacility, covering pandemic risk using an insurance instrument. Payments from the fund are made when certain activation criteria are met based on type of disease, outbreak size, growth and speed. The World Bank estimates that if the fund had existed in 2014 during the Ebola outbreak, the world could have mobilized USD 100 million as early as four months after the outbreak was confirmed and so accelerated the emergency response. In November 2017, the World Bank announced it would be applying lessons learned from the pandemic facility to address other humanitarian crises. Another fundamental benefit of parametric insurance for building resilience is that a policy can be triggered not by the calamity itself (such as crop failure or the resulting human impacts), but by its forebear (such as inadequate rainfall), which through funding early intervention can minimise wider human and financial impacts and costs. For example, one parametric crop policy is triggered on satellite images of grazing land – where a lack of greenery or yellow land indicates the crop is failing. If funds can be made available promptly to a vulnerable region, resources can flow to feed both people and livestock before famine strikes and migration follows.
Index-based insurance operates in a similar way to certain well-established types of product in the derivatives market, such as weather- based derivatives. In fact there is an overlap: what is in essence the same instrument can in many cases be framed either as insurance (assuming the customer has an insurable interest, and the provider is authorised as an insurer) or as a derivative. Professionals with the expertise required to model exposure and design a trigger can and do move between the two fields, and a number of insurance groups have divisions that design and issue derivative instruments. Insurance and derivatives can be used side byside:thisisthecasewiththeWorldBank’s Pandemic Emergency Financing Facility for instance. Alternatively an insurer might issue a parametric insurance policy and hedge its exposure by purchasing a derivative, or pass the risk to the capital markets through Insurance Linked Securities (ILS) products. parametric
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