Parametric Insurance

What Is Parametric Insurance?

Parametric insurance refers to a type of insurance providing policyholders with coverage on the basis of pre-specified conditions, or ‘parameters’ instead of the loss amount or the insured asset’s actual value. It eliminates the requirement for costly and lengthy claims evaluations. 

Parametric insurance policies guarantee payouts based on a data point. Simply put, if a measurable relationship exists between any event and a financial loss, a person can insure it. Note that event triggers and limits are customizable. However, a neutral third party that both the insurance company and the insured agree on must declare or measure the event.  

• Parametric insurance refers to a specific type of insurance product that provides policyholders pre-specified financial protection if the fulfillment of a specific parameter takes place. It simplifies the claim settlement process and complements a traditional insurance policy. 
• Such an insurance policy offers multiple benefits. For example, it safeguards insurers from lawsuits and minimizes moral hazard. 
• A noteworthy disadvantage associated with such insurance policies is basis risk. 
• Unlike in the case of traditional insurance policies, any damage to a property or any physical asset does not trigger a payout for parametric insurance policyholders.

How Does Parametric Insurance Work?

Parametric insurance refers to a certain kind of insurance policy that offers a payout of a pre-agreed amount utilizing a specific parameter or index if a pre-defined event materializes. It offers an added layer of financial protection to policyholders against the occurrence of a certain event by paying a particular amount depending on that event’s magnitude.

One of the key objectives of this type of insurance policy is to complement conventional policies by speeding up the recovery time and filling the gaps in protection. Typically, it can be helpful in the case of uninsured risks, for example, when a natural disaster causes significant property damage. 

One must note that this type of insurance does not identify losses by assigning a value to the insured’s property. Instead, the parametric insurance coverage depends on the event data. 

Such a policy triggers pre-specified payouts based on particular objective parameters, such as rainfall, earthquake intensity, or wind speed. While natural catastrophes or weather events are the usual triggers, crop yield, power outage, and market indices could be possible triggers.  

Considering that the insured catastrophe losses jumped to $112 billion in 2021, many experts believe that parametric insurance policies can help people tackle the challenge they face concerning getting financial protection against epidemiological and natural disasters in the future. 

Cost And Coverage

The cost of such an insurance policy varies from one insurance provider to another. Moreover, one must note that the policy details, for example, the coverage amount and the level of risk involved, determine the premium payable. Generally, for countries opting for this added layer of financial protection, the premium ranges from $500,000 to $2,000,000 for parametric insurance coverage that ranges from $20,000,000-$80,000,000. 

This type of insurance policy provides coverage for losses resulting from catastrophic events, such as — 

• Tropical cyclones 
• Typhoons and hurricanes 
• Wildfires
• Tsunamis 
• Flash rains 
• Droughts 
• Earthquakes,
• Tornados 
• Cyberattacks 
• Epidemics, outbreaks, and pandemics

As noted above, the payout of such a policy depends on the occurrence of a pre-specified event. When any event reaches a measurement that is recordable, the data source agreed upon by the insured and the insurer completes the verification of the measurement, triggering the policy. These measurements can include —

• Water levels 
• Wind speeds 
• Rainfall levels 
• Days without rain
• Wave heights 
• Cyberattack impact on productivity 
• Earthquake shears and shakes, etc. 

Exclusions

One can get an idea regarding exclusions in such insurance policies by going through the points below.

• Traditional policies, for example, homeowners’ insurance policies, safeguard people from an extensive range of damage sources. That said, parametric insurance policies cover only one thing. In other words, one would need three individual policies to get financial protection if losses arise because of wind, theft, and fire damage. 
• Parametric insurance coverage is unavailable for a particular property or physical asset. 
• This type of insurance does not cover all forms of uninsurable risks. In other words, the insurance industry does not have an appetite for some residual risks. 

Examples

Let us look at a few parametric insurance examples to understand the concept better. 

Example #1 

Suppose Company ABC purchases a parametric insurance coverage in the United States. Per the terms and conditions of the policy, the company would receive a pre-determined payout of $25 million in claims settlement if an 8-magnitude earthquake led to damage to the business assets. Within a year of purchasing the policy, an earthquake occurred. As a result of that, the business incurred financial losses. 

To cover the losses, Company ABC initiated the claim settlement process. Once the United States Geological Survey confirmed it was an 8-magnitude earthquake, the insurance provider settled the claim, paying ABC $25 million. The business would not have received any money if any damage to its property occurred because of any event other than an 8-magnitude earthquake.

Example #2 

In February 2024, a renowned German insurance company, Munich Re, unveiled its international parametric insurance team. This new team aims to address solutions concerning natural catastrophe risk transfer. This initiative highlights the company’s commitment to improving its services in the insurance space by taking advantage of innovative parametric solutions.

The team includes seasoned professionals from a variety of backgrounds. With this move, the company is looking to gain more share in the parametric business while minimizing protection gaps and enabling clients to become more financially resilient to the different natural catastrophe risks. 

Advantages And Disadvantages

Let us look at the benefits and limitations associated with this type of insurance. 

Advantages 

• It reduces the moral hazard because the insured and the insurer agree on the payout in advance. This means the risk does not influence the amount the insured will receive if the pre-determined event occurs. 
• Such insurance policies can provide insurance companies with additional security as it involves standardized payments. Moreover, the third-party verification required by such policies can reduce the problems associated with fraud. 
• It eliminates or minimizes the need for probes concerning the value of the damaged or lost property. 
• Such a policy reduces the chances of lawsuits against insurance providers.
• It solves an underinsurance problem associated with market fluctuations and catastrophic events.

Disadvantages

• A key disadvantage of such an insurance policy is basis risk. It occurs if the data utilized to model a certain trigger event is unable to capture every risk element, leading to more losses than what the original model estimated. 
• Individuals do not have much knowledge and awareness regarding such insurance policies. 
• Such an insurance policy is expensive for insurance companies. The cost of distribution and capacity for such insurance products make it challenging for insurers to set a price that appeals to people seeking insurance. 

Parametric Insurance vs Traditional Insurance

Parametric and traditional insurance can be confusing concepts for anyone who does not have any knowledge regarding the insurance industry. People can develop a clear understanding of how they differ by knowing their distinct characteristics highlighted below.  

Parametric Insurance	Traditional Insurance
An event that exceeds the parametric threshold triggers the payout.	Damage or actual loss to a physical asset or property triggers the payout.
It involves a pre-specified payment structure based on an index value or event structure.	The payout depends on the actual financial loss sustained.
The claims process is predictable, transparent, and simple.	In this case, the claims process is complicated.
Claim processing is faster.	In this case, claims processing is relatively slow.

Frequently Asked Questions (FAQs)

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