Parametric Insurance Fills Gaps Where Traditional Insurance Falls Short

Although parametric solutions have been generally available since the late 1990s, they have more recently found their way into corporate insurance. Parametric insurance solutions offer a means to guarantee direct payout after a qualifying event and protect against unpredictable but potentially devastating risks in ways traditional insurance packages cannot.

These insurance solutions may offer alternatives to funding loss that are not possible with traditional insurance products that indemnify for an actual loss sustained.

The basic concept of parametric solutions is quite simple: Traditionally, instead of indemnifying for the actual loss incurred, parametric insurance covers the probability of a predefined event happening (e.g., a major hurricane and earthquake), and pays out according to a predefined scheme. Events may refer to an index-based trigger (e.g., crop shortfall) or an event within a defined area (often referred to as a “cat-in-a-box”). Exemplifying the cat-in-a-box concept, a policy might be structured to pay out 50%, 75%, or 100% of a predefined limit for a Category 3, 4, or 5 hurricane, respectively, happening within a 30-mile radius around the client’s point of interest.

The notion of “point of interest” is an interesting feature of parametric cat-in-a-box solutions. The client defines a “point on the map,” i.e., a longitude-latitude geographical coordinate. Hence, the cover is not limited to the insured’s own locations but can also include infrastructure critical for the client. This provides policyholders with flexibility.

By addressing gaps in the cover such as non-damage business interruption, normally excluded assets, loss of attraction and prevention costs, parametric solutions complement rather than replace traditional indemnity products.

This structure offers benefits beyond expanding coverage. It also reduces complexity from the loss investigation process and provides greater certainty of loss payment recovery compared to traditional insurance products. Therefore, parametric insurance provides customers confidence when it comes to liquidity and speed of payout where predictive loss methods fall short.

For those new to parametric insurance, it is helpful to highlight the key differences between traditional insurance products:

• Nature of risk. Traditional indemnity insurance reimburses the insured for actual losses incurred. In contrast, parametric covers payout according to pre-defined parameters.

• Basis risk. Traditional insurance includes deductibles, exclusions and conditions that balance insurer and insured interests. Parametric insurance, on the other hand, determines risk using pre-defined parameters (e.g., selected index), a pay-out matrix and the defined limit. Both types of cover do have a basis risk (i.e., the payout by the insurer does not cover the incurred losses). However, the basis risk tends to be greater for parametric solutions as it requires the clients to have an in-depth understanding of their exposure to the peril in question. Hence, if the trigger design is not well aligned with the underlying risk exposure, the insured will suffer a loss net of the insurance payment.

• Term. Traditional insurance, especially in North America is frequently offered on an annual basis while parametric insurance may be offered on a one year or multi-year arrangement.

• Structure. Traditional insurance contracts typically have standardized wording. While there may be some customized wordings negotiated, for the most part this is limited. Parametric insurance on the other hand is a customized product with uniquely tailored index and pay-out provisions. This wording is based on each client’s specific needs, ideally aligned with its risk management game plan and the single or multi-trigger nature of the risk. However, parametric wording tends to be much shorter than a standard traditional policy.

• Payment differences and claims handling. Traditional insurance includes payment triggered by actual loss or damage from an insured peril to a physical asset. Parametric insurance payments are triggered by an event exceeding a parametric threshold, i.e., an earthquake with minimum magnitude of 6.5 in a defined geographic area. While the assessment of actual losses with traditional insurance might be both complex and time-consuming (typically requiring a loss adjuster, which often takes months to years), the payout of parametrics is instead a matter of days. For example, some carriers offer terms to pay out within 20 business days after the event has been reported by the client. To sum up, traditional insurance involves reimbursement of actual loss sustained versus a pre-agreed payment structure based on an event’s index value.

It can be helpful to learn about parametric policies by looking at a hypothetical example. For instance, a pharmaceutical company’s drug manufacturing facility is located along the water of a coastal U.S. city that has been affected by rising sea levels. The company’s executives are interested in protecting the facility from the potentially devastating impact of rising water levels around the facility but is having a hard time securing traditional coverage from insurers wary of taking on this risk.

A parametric insurance policy may be able to fill this gap. Based on data from the National Oceanic and Atmospheric Administration (NOAA), an insurer capable of supplying a parametric policy could set up a triggering event of water rising past a certain level above the “mean sea level,” as defined by NOAA. The pay-out mechanism would be defined by how much the water level rises above a certain threshold. For example, the policy might pay out $2.5 million if water levels reach between 16 and 16.5 feet, $5 million if water levels reach between 16.5 and 17 feet, and $10 million if levels rise above 17 feet.

Under these scenarios, the water levels would be measured and reported by a third-party government agency (in this case, NOAA) and the insured would receive the payout immediately upon the ruling.

Parametric insurance policies contain two key elements: triggering events and pay-out mechanisms. These two elements (described below) define the scope of the policy, pricing, as well as other important terms that dictate the amount of financial reimbursement an insured will receive.

1. A triggering event. The insurance pays if an event (e.g., hurricane, earthquake) hits the defined trigger level for the index/measurement reflecting the peril in question. The index in question needs to reflect the exposure of the client. An independent, third party data source, providing the relevant information, is a crucial requirement for the parametric cover as the entire payout is based on this data. Hence, the objectivity and reliability of this source (also in case of a major event) is paramount. If we consider an earthquake event, the United States Geological Survey (USGS) earthquake magnitude indices would be such a source.

Typically, a triggering event might be a hurricane, flood or earthquake where the parameter or index is the wind speed, precipitation or magnitude of the quake. Catastrophe loss such as these are clear triggers but by no means the only ones used to fashion coverage. Other possible triggers often cited include crop yield, power outage, stock market indices or economic damages hitting municipalities due to event shortfalls in a supply chain. All events must be fortuitous and quantifiable to be able to model them.

2. A pay-out mechanism. The pay-out mechanism defines what happens in the case of an event meeting or exceeding the defined threshold, i.e., they determine how much money is paid out to the insured. Consider the recent magnitude 7.1 earthquake that occurred on July 5 in a defined geographical area of California. Say the pre-agreed pay-out parameter was 100% of the limit for magnitude 7.0 or greater. In this scenario, the policyholder would receive a 100% payout in this hypothetical example.

The idea is that a threshold may be set to align with a company’s own business continuity plan and risk tolerance. For example, a company may know that with the risk mitigation measures currently in place, its business can sustain the effects of a magnitude 7.0 earthquake in the prior example. Above that magnitude, the company would require alternative risk transfer solutions. In short, parametric insurance allows management to better align its risk management goals with its overall financial objectives.

One of the most compelling aspects of parametric solutions is the clarity around these payouts. Claims are resolved much faster and without dispute. Contrast that with a complex insurance claim on a traditional policy, which may take a long time to adjust and be paid, due to the need to develop claim details and financial components as well as address issues like valuation and other conditions.

The first parametric products have been around since the late-1990s and were developed by commodities traders as well as energy companies. Companies like AXA, Swiss Re and Munich Re entered the parametric space in the early 2000s. More recently as interest has grown, some of these companies have invested in parametric-focused teams to focus solely on crafting and pricing index-based solutions.

Currently, parametric insurance solutions are mostly used in the reinsurance space around catastrophe risks, but they have started to be used in other sectors such as aviation, special events and projects to protect against pure financial losses resulting from forces outside of an insured’s control.

Of course, more traditional situations covering specific physical assets or property exposed to a pre-defined event, like agricultural, retail, agribusiness, energy, food & beverage, construction, transportation or industrial sectors, remain attractive to companies seeking an indexed approach. In fact, parametric insurance remains especially attractive to a company with more balance sheet risk than traditional insurance can alone address or in a cost-effective manner. The goal of such enterprises is to utilize a parametric approach to mitigate the liquidity risk of a traditional insurance contract.

Insurance buyers considering a parametric solution face a number of challenges that must be reconciled before moving forward. The data demands of parametric solutions are different than for traditional insurance and since the cover tends to be wider, it may be more expensive. Therefore, a buyer must have a strong understanding of the organization’s business model and must be able to develop financial details and significant amounts of data to ensure that the approach will benefit the organization.

Feedback from carriers suggests that more and more customers, especially insureds with more complex liquidity risks, are making more inquiries about parametric solutions. Since both available data and the accuracy of modelling is improving, these solutions become efficient for sophisticated companies.

Parametric policies are also rising in popularity among carriers considering the virtual elimination of the claims handling process, which also presents significant cost savings to the insurer. The predetermined trigger and pay-out mechanism create a situation where it is crystal clear whether or not a company will receive payment and exactly how much is owed. Along these lines, insureds are paid much more quickly when there is limited necessary discovery or claims adjusting.

While the claims handling process becomes much more streamlined after the policy is secured, companies considering parametric insurance policies will likely need assistance in the early planning stages of acquiring a policy. These companies will need to ensure that the triggering event and payout mechanisms are clearly defined and articulated in the policy. Without firm language on what constitutes a triggering event and how much exactly will be paid, companies risk leaving coverage gaps in their policy that could leave them on the hook for devastating losses.

Insurance brokers play a particularly important role in establishing and enforcing a robust process when it comes to purchasing a policy. This process goes far beyond that of traditional products, as parametric insurance is often a new product for purchasing companies. Insurance brokers that are able to truly understand the details of the product and its pros and cons for the policyholder can act as a trusted adviser to clients.

Brokers can also play a role in reviewing and understanding traditional covers and identifying gaps which might be filled with a parametric offering, identifying key loss drivers and selecting and managing insurance carriers on behalf of clients. Additionally, brokers should play an important role in identifying relevant data sources to set up an index appropriate to the exposures or coverage needs of the policyholder, especially for non-traditional risks.

Aside from some additional work upfront, the obvious benefits of parametric insurance will likely lead to continued growing adoption of these coverages. But before securing a parametric policy for themselves, businesses are wise to consult an insurance broker knowledgeable about the intricacies of these innovative products.

Insurance brokers experienced in parametric insurance policies will also be able to parse through complex policy language to ensure an organization’s coverage needs are met. They can also assess a company’s existing coverage and offer guidance in terms of where a parametric insurance policy could fill in coverage gaps or provide an extra layer of coverage.