What is Parametric Insurance and why is it your best ally in a Hard Market?
Emerging as a game changer in the insurance industry, parametric insurance is supporting many large and small companies with its unique characteristics. In this article, learn how this new generation of insurance’s innovative use of data and transparent operations can enhance resilience and help companies bounce back from natural catastrophes and the climate risks they face. By delving into the question ‘what is parametric insurance?’, find out why this cutting-edge solution serves as a critical ally, in the wake of an increasingly hard market.
In an InsTech poll on the obstacles to the broader uptake of parametric insurance, ‘lack of education and awareness’ was chosen by over 50% of respondents. However, given the growing adoption of parametric insurance by corporates and risk managers, it is hard to impute a lack of education and awareness to the complexity of its concept, but rather to its unfamiliarity.
Parametric Insurance: Definition and Background
In a nutshell, parametric insurance refers to the contract that pays out a pre agreed indemnity when a predefined event occurs by or beyond the predefined parameters. It is specialized insurance against disasters caused by climate change, where the loss is extensive and difficult to measure with traditional methods. The ‘parameters’ here work as the objective indicators of the extent of natural disasters and criteria for the coverage clients can demand. For example, magnitude for earthquakes, water level for floods, and soil moisture for drought can be parameters.
Parametric insurance emerged from the need to respond to the increasingly exacerbated climate crisis and its accompanying risks. This new solution has since then established its innovative position in the changing insurance landscape, meeting client needs to maintain natural risks covers and optimize their insurance budget in a hard market. With the advance of new technologies and data, parametric insurers can offer extremely modern models rather than solely rely on historical claims.
How Does Parametric Insurance Work?
The mechanism of parametric insurance is much simpler and more streamlined than traditional insurance in many aspects. The process can be explained in three steps:
The definition of ‘parameter’ is agreed upon. A parametric insurer, a broker, and a client define the coverage together based on historical data, potential risk, and other relevant aspects. As a result, each client gets their customized insurance depending on the degree of exposure to threats, and their available budget.
After the ‘parameters’ are decided, cutting-edge technologies are employed to monitorhow things evolve around the parameters. To monitor the on-site threats and see if the threshold is met in near real-time 24/7, data sources such as IoT, satellite imagery, stationary sensor, radar, or sonar data, will be grafted onto the insured area. The data collected from these tools is integrated and interpreted with machine learning algorithms, image recognition techniques, or advanced statistics that are constantly generated and updated.
When the threshold is met or exceeded, clients receive the pre-agreed indemnity in just a few days. Complicated and lengthy loss assessment is not required.
What defines parametric insurance is the precise protection that it offers. Indeed, when a predefined event occurs, such as flood, wildfire, or earthquake, parametric insurance pays out in a rapid and transparent manner.
What Are the Advantages of Parametric Insurance?
Is parametric insurance better than traditional insurance after all? This is a difficult question to answer because it is an incorrect question. Nothing is better than anything. Parametric insurance and traditional insurance are not conflicting, but rather complement each other. Parametric insurance exists to resolve the drawbacks and the hard market of traditional insurance that corporates grapple with. It is designed to provide bespoke contracts, simplify the pay-out process, optimize costs, and build resilience, especially on hard-to-assess intangibles such as business interruption.
Bespoke insurance contracts
Pain point: Traditional insurance contracts rely primarily on historical data, tailoring customers to their predetermined insurance products. This has two drawbacks: one, history is a poor predictor of future exposures especially in the field of climate risks. Two, customers mitigation actions – elevating buildings to be prepared in case of a flood, reinforcing roofs to withstand stronger hurricanes, reviewing civil structures to better resist earthquakes – are a key component of resilience and need to be accounted for in building their insurance protection. Traditional, history-based solutions are not fit for purpose, and often result in higher prices, lower limits, and little to no customization.
Parametric solution: In designing a parametric insurance protection, parameters are first required to be customized for each client. As a result of bespoke statistical and machine learning models for risk analysis, each client can have tailor-made parametric insurance based on their risks, incorporating protection measures, and matching their budget. As such, parametric insurance provides solutions to situations that are difficult to interpret and eliminates issues that would otherwise occur with traditional insurance, such as document processing, conflict of interest, years of delay in accounting for prevention measures in the premium, and so forth.
Streamlined pay-out process
Pain point: In the event of damage due to a natural catastrophe, in traditional insurance, you need to prepare documentary evidence and often wait for the insurer to appoint an expert to measure the extent of loss that the premium is supposed to cover. This process is usually very intricate to handle and takes an average of 18 months to be completed.
Parametric solution: In that sense, the immediate payment solution is probably the most vital and attractive characteristic of parametric insurance. Once the predefined natural events occur and the fixed parameters are triggered, it directly triggers the claim payment. And of course, no lengthy documentation process nor experts’ investigation need to be provided. This is a critical benefit especially for the micro, small and medium companies in that many of them are not able to sustain or progress their business whilst waiting for compensation for months to years.
Affordable insurance costs
(Global insured natural catastrophe losses by peril – 2013 to 2021)
Pain point: Losses caused by natural catastrophes have never been and still are not well insured today. It is more pronounced in developing or emerging countries: insured loss is less than 10%, and in some cases it is close to zero. As illustrated in the graph above, following the increase in natural disasters and extreme weather events from the climate crisis, the coverage the insurers are willing to provide is getting narrower, and the supply of insurance is becoming lower. This ultimately leads to insurance cost is spikes.
Parametric solution: As the insurance industry faces an increasingly hard market driven by the climate crisis, it is evident that insurance needs to reinvent itself. Backed by state-of-the-art technologies and with a considerable amount of data used to assess and analyze climate risks, parametric insurance is able to offer large-scale insurance against these risks at a precise premium and based on objective data.
Covering NDBI (paralysis of the supply chain)
Pain point: Some catastrophes do not create material damage but can cause operational loss. Traditional insurance dogma where business interruption is only covered when arising directly from material damage is simply not fit for today’s business models. Intangible assets, complex supply chains, and business continuity plans call for a more flexible approach to revenue loss insurance, where the pre-existence of material damage is no longer a requirement.
Parametric solution: Parametric insurance even covers non-damage business interruption: the triggering of the index gives rise to a payout, regardless of the tangible or intangible nature of the loss. This new solution frees companies from the constraints of traditional insurance and is an excellent initiative to go beyond current coverages.
Parametric insurance provides corporates with price-optimized and transparent solutions in the insurance industry, which has become an increasingly hard market due to climate change and its accompanying risks. With data at its core, parametric insurance fills the gaps and addresses the challenges that current traditional solutions cannot resolve.