Parametric insurance - what you need to know

Parametric insurance has been available for decades, but the past few years certainly have seen a boost in popularity for such index bases solutions also outside the usual applications in the Agriculture and Energy sectors. A strong driver for this has been a fundamental shift in corporate business models moving from physical assets to intangible assets, thereby exposing gaps and inefficiencies in their traditional insurance programs. With its transparent and fast claims settlement, and ability to offer a pay-out without actual physical damage to an asset, parametric or index-based insurance solutions can be a tool when looking at ways to transfer risks previously deemed to be uninsurable.

From conversations with brokers and clients, we believe that parametric insurance solutions will take an even more prominent role in the future of insurance, primarily because they allow us to stretch the envelope of insurability, eliminate all complexity of a loss investigation and give customers the confidence when it comes to speed of pay-out and liquidity.

An important point here is that parametric insurance solutions are designed to complement, and not to replace, traditional insurance programs. Because of their fundamental nature, index-based solutions are an ideal instrument to cover pure financial losses that impact businesses without causing physical damage to their assets. Examples of such cases include lower spending due to changed consumer sentiment after an Earthquake or supply chain disruption due to a long and hot summer resulting in river levels too low for commercial vessel traffic.

Parametric vs traditional insurance solutions

Most people will understand how traditional insurance works. A premium is paid in return for a promise to indemnify the actual loss incurred from an incident. Payment is made only after a loss assessment or investigation, with the goal to put the insured back in the position they were prior to the event.

Parametric insurance is fundamentally different as it covers the probability of a pre-defined event happening. Essentially it is an agreement to make a payment upon the occurrence of a triggering event, and as such is detached of an underlying physical asset or piece of infrastructure.

The parameter to index triggering the insurance must be objective transparent, and consistent. Important is that neither the risk taker nor the insured can influence the event or its reporting. This is why indices around weather and “Acts of God” are still the most popular in parametric insurance

Parametric solutions – more relevant than ever

Businesses today are increasingly looking into parametric insurance solutions to complement their traditional programs, and they have compelling reasons to do so:

Climate change has led to an increased frequency and severity of weather events. Just looking at the Asian region over the past year. We have seen Super Typhoon Mangkhut devastating the Philippines and Hong Kong, and during a few months in 2018 Japan has been ravaged by heatwaves, floods and two typhoons.

Early estimates by Swiss Re’s Sigma expect Natural Catastrophes globally to have caused USD 146 billion of economic losses of which only USD 71 billion covered by insurance, exposing a continuing trend of a widening protection gap. With Mother Nature becoming increasingly unpredictable we see companies today beginning to review their insurance cover through a new lens – looking for ways to fill in gaps and complement their existing traditional insurance programs. With the potential of natural catastrophes to cause wide area damage leading to high non-damage business interruption (NDBI) losses, parametric insurance solutions are a logical application, as they can provide protection for exposures creating challenges even for those with a sound Business Continuity Plans in place.

Today, with the tremendous advancements in technology, data collection is improving continuously which allows for modelling of previously deemed “uninsurable” risks. With the use of sensor technology, data is even helping clients to mitigate risks before a loss occurs. At the same time, the data from these networks can be used to structure and model new and innovative parametric risk transfer solutions from earthquake intensity covers in Japan to river water level insurance in Germany.

Better, more accurate and more localized data also means that there is increased risk assessment certainty and more transparency for clients. This is actually good news for any risk manager as the result is better indices which means lower basis risk. Ultimately this allows insurers to structure more tailored and more efficient solutions.

The future is now

The transparency and quick liquidity that a parametric insurance solution allows, along with the ability to cover otherwise difficult to insure risks, makes it the perfect complement to traditional insurance programs. This is a stark contrast from the simple insurance beginnings in medieval Italy, where if back then a ship did not return from its journey, it would remain a mystery whether it had been sunk by a strong storm – or by a sea monster.