A novel type of insurance product has been gaining traction amid increasingly extreme weather events that have roiled the industry. Known as “parametric insurance,” these contracts insure a policyholder against the occurrence of a specific event by paying a set amount triggered by a predetermined parameter. In other words, it pays out based on the magnitude of the event rather than the magnitude of the losses in a traditional indemnity policy.
Most people understand how traditional property insurance works: Typically a premium is paid in return for a promise to cover the actual loss incurred as a result of an incident or named peril (flood, fire, etc.). Payment is made only after a loss assessment and investigation, with the goal to put the insured back in the position they were prior to the event.
However, the process can also include litigation during the claim adjustment period that could delay the final settlement of a claim for several years. There is also the possibility that the payout won’t fully reimburse the actual losses sustained from an event.
Parametric, or “index” insurance, by contrast, is an agreement to make a payment upon the occurrence of a triggering event and, therefore is detached of any underlying physical asset. A triggering event could be an earthquake, hurricane, or flood where the parameter is the magnitude, wind speed, or precipitation respectively.
While Natural Catastrophes or weather events are the most common triggers, parametric policies can cover any type of objectively measurable event that causes a loss and can be modeled. For example, construction companies could define a trigger such as a number of days with precipitation. Some parametric policies may have more than one trigger that must be met before payout occurs, or may have several triggers depending on the situation, such as a gradation in payout based on the intensity of a storm.
Parametric insurance providers say claim settlements are faster with their products, with funds typically arriving within weeks and allegedly without dispute as the triggering event is objectively measurable. This in turn eliminates worries about post-loss cash flow. What’s more, if the parameters of the policy are met, it gets paid regardless of whether any losses were sustained. Additionally, the vehicle offers financial protections against losses that are hard, or even impossible, to get insurance for in some cases.
Parametric insurance policies are typically tailored to the specific needs of the policyholder. For example, a farmer could insure their corn crop against drought during July and August with a policy that is triggered when soil moisture levels drop below a certain level. The payment would be automatic once triggered, and depending on how the contract is written, could trigger a larger payment if the moisture shortfall becomes more severe. Another option would be a parametric insurance with a yield-based index. This involves collecting data on agricultural yield across an area or region and paying out to policyholders when the average yield in their area has dropped significantly.
Notably, through parametric contracts, risk managers can clearly define events that will and will not pay claims, as well as the sum of those claims. It also completely eliminates the claim adjustment process, which can be costly for both insurers and policyholders.
For parametric insurance providers and policy holders alike, one of the most critical factors is accurate modeling. In the instance of a farmer that has a policy insuring against a certain amount of rainfall within a predetermined period of time, it matters a lot where and how that data is being collected. Those underwriting the policy likewise need to utilize highly accurate data analytics and risk models to keep costs low while enabling accurate protection.
While parametric insurance has traditionally been used for public sector transactions and agriculture insurance, solutions are now increasingly being deployed beyond mainstream property/casualty exposures. For example, New York-based Parametrix Insurance Services Inc. monitors cloud providers for outages as part of its triggering mechanism for cloud downtime coverage. London-based Intangic MGA offers up to $15 million in coverage for losses from material cyber breaches, using the measured level of malicious activity targeting a company and the subsequent loss in value as triggers.
Parametric insurance is expected to become more mainstream, particularly if climate change continues to intensify weather extremes and more traditional insurance companies drop coverage in certain areas. Startups are leading the charge into this type of insurance but more traditional providers are also starting to offer some parametric coverage. Data from Allied Market Research shows that globally, parametric insurance grew into a nearly $12 billion business in 2021 and is expected to more than double its size by 2031. (Sources: Center for Insurance Policy and Research, Bloomberg, The Wall Street Journal, AON)
