What exactly is parametric insurance?
Parametric insurance, also known as index based cover is a non-traditional type of coverage often used in circumstances where a normal insurer would decline indemnity coverage, or used to compliment an existing policy. Parametrics is designed to make policy payouts easier and address more complex risks such as climate change.
How does parametrics work?
Parametric insurance is based on a specified set of criteria being met, and a predetermined amount is paid out when each set of criteria is met. Let’s look at an example. A manufacturing facility for a large company is located in a location close to the water in an industrial zone. Rising water levels are beginning to cause worry, and are expected to rise. Most traditional insurers would not offer coverage due to the high risk. Parametric coverage would offer a staggered payout based on the rising water level. For instance, if the water level rises between 1-3 inches, the policy would pay out 15%. If the water raises between 3-5 inches, the policy pays out 50%. This also shortens the claims process, as data is pulled from indexes such as the National Oceanic and Atmospheric Administration (NOAA) which would tell the insurer what the levels have changed right away, resulting in an immediate payout. This is applicable for severe weather storms, water loss, wildfires and other climate change issues. The greatest advantage to parametric policies is that there is often no disputes or court battles which could occur in a traditional insurance contract which are often more open to interpretation. This naturally results in very fast payouts for parametric coverage.
Parametric policies are built on two elements, a trigger when an event occurs and a payout structure. The trigger occurs when the event happens such as an earthquake or tsunami, and the payout structure defines how much is reimbursed. For instance, a hurricane could be a trigger, and the payout structure is based on the strength of the hurricane, rather than assigning a number to the actual damage inflicted on the property.
When is parametrics commonly used?
Large reinsurance companies such as Munich Re and Global Re started using parametrics in the early 2000’s to address global warming and other climate risks. Since then, it’s most commonly used to address catastrophe risks, however recently there has been a shift in momentum and we are starting to see it being used in special projects, events and aviation to protect financial losses outside of the client’s control. Large enterprises such as agribusiness, energy, construction, retail and industrial sectors are moving towards looking at parametrics as it provides a more indexed approach. This is helpful when trying to mitigate the liquidity risk of a traditional contract.
What should I look for when considering parametric coverage?
The demands of this type of coverage require large amounts of data to be assessed, often resulting in more expensive policies. Thus, companies must have a strong financial understanding of their organizational needs in order to assess if this is a worthwhile route to go down. For sophisticated companies with complex financial risks that traditional companies with conventional policies have difficulty addressing, this may be a highly cost effective solution. During the next few years, modeling and available information is heavily improving, which will result in greater use of index based risk assessment and product offering.