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In recent years, product innovation and data analytics 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 risks.

From conversations with brokers and clients we've found that while there's significant interest, there's still some confusion around the concept of "parametric insurance" – what it is and how it works. Therefore, in this first article of the series we aim to shed some light on the concept.
 
Demystifying "Parametric" insurance solutions
Most people will 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. With parametric solutions, being a relatively new concept, the level of understanding tends to vary.

So what exactly is a Parametric insurance solution?
Don't be put off by the term 'parametric' – even if it does sound a little complex. It's actually very straight forward in a practical sense.

Fundamentally, parametric (or index based) solutions are a type of insurance that covers the probability of a predefined event happening instead of indemnifying actual loss incurred.

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. Let's break this down further into two key components.

A parametric solution always consists of the following:

1.    A triggering event

The insurance cover is triggered if pre-defined event parameters are met or exceeded, measured by an objective parameter or index that is related to an insured's particular exposure.

In practice, this event could be an earthquake, tropical cyclone, or flood where the parameter or index is the magnitude, wind speed or precipitation respectively. Whilst Natural Catastrophes (Nat Cats) or weather events are the most prominent triggers, there are many other applications. Possible triggers could also be market indices, crop yield, power outage and more.

The key criteria for an insurable trigger is that

(i)  it is fortuitous and
(ii)  it can be modelled.

2.    A pay-out mechanism

A pre-agreed pay-out if the parameter or index threshold is reached or exceeded, regardless of actual physical loss sustained.

For example, USD 10 million if a magnitude 7.0 earthquake occurs in a defined geographical area, or USD 30 million if a category 5 tropical cyclone occurs in a defined area, or USD 50,000 for every millimetre of cumulative rainfall above a certain threshold.

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.

What is a parameter or index?
A suitable parameter or index is any objective measure that is correlated to a specific risk and ultimately to a financial loss for the insured. This is a "measurable index" related to a "scenario". For example rainfall related to delaying a construction project or earthquake related to damage to a corporation's physical assets.

Any parameter or index that is used as the basis for a parametric solution must be objective (ie. independently verifiable), transparent, and consistent. Generally we are looking for indices that are easily measurable and reported quickly and effectively to ensure prompt pay out. 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.

Some examples of agencies and respective parameters or indices:
-    Singapore National Environmental Agency (NEA) Pollutant Standard Index (PSI)
-    Hong Kong Observatory (HKO) typhoon warning signals
-    Japan Meteorological Agency (JMA) seismic intensity

-    US Geological Survey (USGS) earthquake magnitude
-    Australian Bureau of Meteorology (BoM) tropical cyclone category

Traditional insurance versus parametric/index-based covers – what's the difference?
Often we are asked about the difference between traditional indemnity based insurance versus parametric insurance covers.

An important point to drive here is that parametric insurance solutions are not designed to replace but to complement traditional insurance programs. They can fill the protection gaps left by indemnity insurance like deductibles, excluded perils, scarce capacity or pure financial risks where the insured has no control over the underlying asset – take contingent business interruption for example.  

The key differences between traditional indemnity and parametric insurance are outlined in the table below and relate to the payment trigger, recovery, basis risk, claims process, term and structure.

Traditional insurance Parametric solutions

Payment trigger

Payment triggered by actual loss of or damage to a physical asset.

For example, a fire causing physical damage to your property resulting in a physical damage and business interruption loss.
Payment triggered by event occurrence exceeding parametric threshold.

For example, an earthquake of minimum magnitude of 7.0 within a defined area.

Recovery

Reimbursement of actual loss sustained.

For example, the assessment and claims investigation of actual loss sustained due to a fire.

Pre-agreed payment structure based on event parameter or index value.

For example, increasing pay-out amounts with increasing earthquake magnitude.

Basis risk

Policy conditions, deductibles and exclusions.

Traditional policies often include significant deductibles and exclusions, which are an efficient instrument in conventional covers to align the interests of the insured and the insurer.

This can however leave the insured party with a significant amount of retained risk.


Correlation of chosen index, the pay-out, and the loss sustained.

What is basis risk?
Basis risk is the risk that the trigger index does not perfectly correlate with the underlying risk exposure resulting in the client suffering a loss but the parametric insurance not being triggered.

Whilst basis risk can never be fully eliminated when it comes to index based insurance, it can minimized by more sophisticated structures such as double trigger events or staggered pay-out structures.

For example, in the case of a tropical cyclone, having a partial pay out for lower category storms and progressively increasing pay out for stronger storms.

Claims process – loss assessment and payment

Complex and based on loss adjuster assessment.

This can take months to several years depending on the complexity of the loss.

Transparent, predictable, based on a parameter or index, quick settlement.

Pay out can be as quick as within four weeks after the event as there is no need for loss adjustment.

The only thing we need to establish or measure is the index we are covering. This is typically done by a third party agent – for example national weather services.

Term

Usually annual

Multi-year deals while possible are more difficult to structure and tend to be less common.

Single or multi-year

Multi-year deals are common, and possible up to five years.

Structure

Standard products and contract wordings; some customization

The level of customization for a traditional indemnity solution is usually limited as the insurer will still be working off of a standard industry wording.

Customized product with high structuring flexibility.

Parametric wording templates can be shared to provide a basic sample. A general "standard" wording does not exist as each of the structures will have a uniquely tailored index and pay-out structure. This is bespoke to each single client's needs and applications and could be a single trigger, multi-trigger etc.

   
Summary
Parametric insurance solutions can achieve things that are not possible with conventional insurance products indemnifying on an actual loss sustained basis. They push the envelope of insurability, 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, in our next article we will try to correct and bust some of the most common misconceptions we often see and hear.

Stay tuned.

Find out more: Download "Innovating Together - Examples of Innovative Risk Solutions"

Andre Martin

Innovating together – Examples of Product Innovation

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