Insurance is finally changing. New, reliable data sources, digital technologies, and shifting customer dynamics are the driving forces behind this transformation. Customers are demanding more convenience, faster payments, and affordable, practicable solutions to manage their risks. Climate change and an increasing number of people being exposed to weather extremes make it more important than ever to build climate resiliency.
Parametric insurance is not new. In fact, it has been successfully applied for years in life insurance and in risk-linked securities, such as catastrophe bonds. One of the better-known examples of parametric insurance is the Caribbean Catastrophe Risk Insurance Facility, which was established in 2007. This facility pooled the risk of 16 Caribbean and Central American countries and purchased parametric insurance against weather catastrophes, such as hurricanes, extreme rain and earthquakes.
Driven by the mentioned trends parametric risk management is now primed to go “mainstream” and make a much broader impact to consumers.
What is Parametric Insurance?
The concept of parametric insurance is simple: a pre-defined payment occurs if a pre-defined parameter surrounding an event is triggered. For example, the event could be a hurricane that unleashes winds over a certain speed, the “trigger”. The insurance contract defines the specific parameters (metrics, characteristics, and thresholds) of events that will trigger a payment.
This design has many advantages. As the payment amount is established in advance and not linked to the actual loss, like in conventional indemnity-based insurance, there is no need to adjust the claim after an event. Instead, claims can be paid out almost instantly. This is important as speed is a crucial factor for individuals and organizations to stay resilient and recover after a disaster.
A key requirement for parametric insurance is reliable and consistent data that is highly correlated with an anticipated loss and comes from an independent, recognized, and well-respected organization, such as the National Oceanic and Atmospheric Administration (NOAA) for hurricanes.
Parametric insurance is appealing to many customers because it offers protection and financial support while eliminating everything people dislike about insurance: complicated policy forms, high deductibles, a long-drawn-out claim process, or claim disputes that sometimes end up in court. For example, over 1,250 business interruption lawsuits have been filed in US courts against insurers for claims arising from shutdowns in response to COVID-19.
Where is it Used?
There are many areas where parametric insurance is already used including hurricanes, earthquakes, droughts, excessive rainfalls, floods, extreme high or low temperatures, and many more. Parametric insurance is also starting to see traction for non-tangible losses, such as travel delays, business interruptions, and even power outages. With more accurate data from weather stations, satellite images, and other sensors as well as improved risk modeling capabilities, there will be even more applications in the future.
Several recognized insurance players around the world have already released parametric products. For example, Swiss Re offers parametric products for wind storms and earthquakes. Sompo has introduced parametric crop insurance. And AXA offers parametric insurance for renewable energy, agriculture and the hospitality industry. There are also several new players that offer parametric insurance specifically targeting consumers. Parachute Insurance for instance is developing a parametric hurricane protection product for homeowners.
Benefits of Parametric Insurance
Parametric insurance has many advantages for customers as well as for insurers.
Benefits from a customer’s perspective:
- Fast – When a policy is triggered, payments can reach customers almost immediately.
- Easy – The policy language is explicit and clear. Customers do not have to file a claim or deal with a claim adjuster.
- Affordable – With easier underwriting and practically no claim adjudication, costs can be significantly reduced, making it affordable for many customers.
From an insurer’s perspective:
- Efficient – Parametrics offers insurers a chance to reduce their notoriously high expense ratios which has been hovering at around 30% of premiums.
- Fast – The value of claims is known almost immediately, and maximum losses are capped, even in a catastrophe.
- Growth – Parametrics offers insurers an opportunity to expand into new risks that were previously uninsured or underinsured.
Parametric insurance also has downsides, most notable the basis risk and lack of customer literacy.
Basis risk is the risk that a customer suffers a loss but doesn’t receive a payout. This might be due to the fact that parametric insurance only triggers a payment when an index meets a specific threshold, not by the actual loss itself. You can reduce basis risk by choosing an index highly correlated to the actual loss as well as by granular data. Also, it is important to keep in mind that even conventional insurance includes “basis risk” in the form of policy wording with deductibles, exclusions, and limits.
The other concern is consumer illiteracy, meaning consumers might not fully understand the payout process of a parametric product. It is important to stress that parametric insurance is not as comprehensive as traditional insurance and is therefore often marketed as a supplemental cover.
Until recently, mostly governments and large corporations were buying parametric insurance, but it is now gaining momentum for smaller businesses and individuals. The rise in parametric insurance can be attributed to a few connecting factors. Customers are demanding easier insurance products with faster payouts. With more frequent and intense natural catastrophes, there is a growing need for more affordable risk management solutions. Finally, new data sources make it possible to develop new parametric insurance products. When designed well, parametric insurance products can help satisfy many of these customer needs and keep the insurance industry evolving with the times.