What is parametric insurance?

In recent years, product innovation and data availability have expanded the scope of commercial insurance solutions to offer coverage for a wider range of threats, exposures and perils. With its transparent and fast claims payment and ability to offer a payout without actual physical damage to an asset, parametric or index-based solutions are often brought to the table of discussion when covering hard to insure physical risks or pure financial exposure.

From conversations with brokers and clients we've found that while there's significant interest and an increased understanding around the concept of parametric insurance, there's still some misperceptions that remain – how it can be used and how it works. Therefore, in this article we aim to shed some light on the concept.

Most buyers of insurance conceptually understand how traditional commercial property insurance works: Typically a premium is paid in return for a promise to cover the actual loss incurred of an incident or named peril. Payment is made only after an actual loss assessment and investigation, with the goal to put the insured back in the position they were prior to the event.

But parametric insurance – while a newer concept – is arguably even more simple than traditional commercial property insurance.

Fundamentally, parametric (or index based) solutions are a type of insurance that covers the probability (or likelihood) of a loss-causing event happening (like an earthquake) instead of indemnifying the actual loss incurred from the event.

It is an agreement to make a payment upon the occurrence of a covered event meeting or exceeding a pre-defined intensity threshold, as measured by an objective value (or parameter – hence the name 'parametric insurance').

The covered events could be earthquakes, tropical cyclones, or floods where the parameter or index is the magnitude, wind speed or water depth respectively. The key criteria for an index to be used as parametric insurance trigger is that:

• it is fortuitous and
• it can be modelled

If the parameter or index threshold is reached or exceeded, the insured is eligible to collect payment.

For example, clients could collect payouts if a magnitude 7.0 earthquake or a category 5 tropical cyclone occurs in a defined geographical area.

The threshold is usually set in such way that aligns with a client's own business continuity plan and risk tolerance. For example, a client may know that with the risk mitigation measures currently in place, their business can sustain the effects of a magnitude 7.0 earthquake. Above that however, they would require alternative risk transfer solutions. The probability of these threshold levels will naturally be reflected in the premiums charged.

A suitable parameter or index is any objective measure that is both reported by an independent third party (neither the insured nor insurer) and correlated to the underlying hazard which can result in financial loss for the insured.

This ensures we can pay out promptly if the event meets the necessary intensity. This is why indices around weather and "Acts of God" are so popular in parametric insurance.

Some examples of agencies and respective parameters or indices:

• Japan Meteorological Agency (JMA) seismic intensity
• US Geological Survey (USGS) earthquake magnitude or ground shaking intensity
• Australian Bureau of Meteorology (BoM) tropical cyclone category
• National Hurricane Center (NHC) Saffir-Simpson category
• Moody's HWind wind speeds
• Corelogic hail sizes

Traditional insurance and parametric insurance play complementary roles in an insured's overall risk transfer strategy. Traditional insurance is best used to protect owned physical property – there are well-established risk assessment methodologies, contract wordings and coverage options that are standard in the industry. After an event, the payments are based on the actual loss sustained, subject to the terms and conditions of the policy. The ability of the insured to recover funds is almost always predicated on direct physical damage occurring, and the money received will, in theory, be used to repair the damage incurred.

However, in the case of parametric insurance, the payment is tied to the loss-causing event occurring, and not the actual loss sustained, resulting in the scope of coverage much broader. Parametric insurance can provide protection against the losses that traditional insurance can't, or won't, such as difficult to underwrite assets or financial exposure. Parametric insurance can also be used to increase the amount of coverage available to certain natural perils (i.e., named windstorm) that are of primary concern to the insured.

Parametric insurance can provide coverage and protection that isn't available or offered by the traditional insurance market. They're transparent and straight-forward, eliminating all complexity of a loss investigation process and can give customers the confidence when it comes to liquidity and speed of payout.

In this article we've looked to get down to the basics and demystify the fundamental concept. Now that we've established the basics of what a parametric insurance is, read about some of the most common misconceptions - 10 myths about parametric insurance.