What is parametric insurance?

Parametric insurance products are developing rapidly around the world. They’ve been described by global law firm Clyde & Co as “an elegant solution for risk-transfer concerns” and are lauded as attractive alternatives and enhancements to some traditional insurance policies. 

But what exactly is parametric insurance?

Let’s start at the beginning. The Oxford Dictionary defines the adjective parametric as “relating to or expressed in terms of a parameter or parameters”. When applied to insurance, that means coverage is triggered by a parameter – i.e. a metric or an index - that is easy to determine.

Pre-agreed payment for a claim is guaranteed upon the occurrence of a triggering event, which needs to be a pre-defined parameter or metric related to the insured’s particular exposure.

“Broadly, it’s an insurance program that is triggered, and/or paid very simply using an index rather than words,” explained Steve Harry, risk finance consultant in Marsh’s Financial Solutions Group.

Here’s an example in travel insurance: if an insured purchases a parametric travel insurance policy before making a train journey and their train is delayed by X amount of time, the insured will receive an automatic and pre-determined pay-out if the delay time of X (e.g. two hours) is within the policy’s parameter or index threshold.

How do you determine the parameter or index threshold?

An insurable trigger needs to be fortuitous and insurers need to be able to model it. According to Swiss Re Corporate Solutions, “any parametric or index used for the basis of a parametric insurance solution must be objective (i.e. independently verifiable), transparent, and consistent.”

The threshold for the trigger is usually set so that it aligns with an insured’s risk tolerance. For example, an insured might have adequate risk mitigation in place to deal with anything up to a category 4 tropical cyclone. For any storm above a category 4, they might want an alternative risk transfer solution in the form of a parametric policy.

Swiss Re Corporate Solutions continued in its explainer: “Important is that neither the risk taker nor the insured are able to influence the event or its reporting to avoid moral hazard. This is why indices around weather and ‘Acts of God’ are so popular in parametric insurance.”

Which clients are best suited to parametric policies?

Parametric solutions are not designed to be stand-alone insurance policies. Rather, they exist to fill protection gaps in more traditional insurance programs. For example, a client with very high deductibles or multiple exclusions on their policy may want to enhance their risk transfer with some parametric coverage.

“Buyers are now more sophisticated in the way that they look at their insurance, and they understand some of the limitations of a conventional insurance policy,” commented Harry. “Some people like the uncertainty that gives them, in that they can always argue about a policy contract, and other people like the certainty that an index-based product would give them.”

The scope of parametric insurance solutions is growing. Initially, they only really covered natural catastrophe risks, earthquake and weather exposures, but the industry is now making great strides around non-physical damage business interruption losses. A commercial client might lose a certain amount of income over a period of time, which could trigger a pay-out without an identified event like a rain storm or an earthquake occurring. This will open the possibilities of parametrics to more and more clients.

How does the claims process differ between traditional insurance and parametric solutions?

The claim process is one of the most exciting and attractive parts of a parametric solution. Whereas traditional indemnity claims can take months or years to solve depending on the loss adjuster assessment and the complexity of the loss, a pay-out when a parametric policy is triggered can be sent within four weeks.

There’s no need for loss adjustment in parametric solutions, as long as the trigger or index is established, normally by a third-party agent like the national earthquake center or a weather agency.     

Why should brokers be interested in parametric solutions?

It’s another tool in your tool box. The goal of the broker is to transfer as much of a client’s risk as possible in order to provide peace of mind and business/life continuity. If a broker can place a strong policy and then enhance that by filling any coverage gaps with a parametric solution, they can offer a more holistic risk transfer service.

Where should insurance brokers and risk managers start in looking at parametrics?

When considering parametric solutions, brokers need a really good understanding of their commercial client’s business model. The data demands of parametrics are more complex and, because the cover tends to be wider, it can be more expensive.

“For risk managers [dealing with insurance brokers], taking the time to understand their firm’s ability to withstand future ‘shocks’ and gaining the support of the board are crucial first steps to incorporating parametric insurance solutions into their overall risk management strategy,” said Harry.

Put simply, before purchasing a parametric policy, brokers and their clients need granular understanding of the loss exposures in play and the client’s economic ability to withstand future losses.

What lies ahead for parametric insurance?

As risks evolve and insureds look for more innovative ways to transfer their risk, parametric solutions are likely to gain in prevalence. A Clyde & Co report entitled Building a resilient world: How parametric insurance can help close the protection gap, suggests that with the level of support currently being given to parametric solutions by governments around the world, together with demand from buyers and the proven success of parametric insurance products to date, regulators and law makers are expected to support and encourage the responsible roll-out of parametric insurance rather than attempt to hold it back.

“With continued support and increased understanding, parametric insurance can fulfil its vast potential and, alongside traditional insurance and other novel forms of risk transfer, play a key part in closing the protection gap,” commented Nigel Brook, partner, Clyde & Co.