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What Is Parametric Insurance?

Extreme weather events have made insurance companies leery of offering coverage in disaster-prone areas. But insurance is necessary, and businesses are paying more for fewer coverage options in many locations and industries.

Enter parametric insurance.

While traditional insurance pays out based on the severity of the damage, parametric insurance pays out based on the severity of the event. Parametric insurance supplements traditional insurance policies to increase cash flow after a foreseeable event.

Traditional insurance 

Traditional insurance reimburses you for a loss, and the payout makes you whole again. You pay a premium based on ratings, risk and the value of what you’re insuring. If you have a claim, an insurance adjustor will assess the damage and assign a value to the loss. The insurance company will then decide whether your policy covers you. 

You need proof of your loss, like damaged items and business receipts. If your claim is denied due to exclusions or coverage gaps, you must appeal the claim or sue your insurance company for indemnification. If a claim takes too long to pay, you can suffer trailing losses or even bankruptcy. 

Parametric insurance 

Parametric insurance guarantees a payout based on a data point: If there is a measurable data relationship between an event and a loss, you can insure it. Instead of indemnifying losses by assigning values to property or revenue, parametric insurance pays out based on event data. 

Parametric insurance can:

  • Decrease or eliminate the need for investigations into the value of lost property or business income
  • Reduce lawsuits against insurance companies for repayment of losses
  • Solve an underinsurance issue related to catastrophic events and market fluctuations

Limits and event triggers are customizable, such as tiered payouts based on the parameters you set in the insurance contract.

Coverage for a wide range of global risks

You can cover risks across any area or industry worldwide:

  • Retail
  • Hospitality and leisure
  • Manufacturing
  • Finance
  • Entertainment
  • Construction
  • Transportation and logistics
  • Health care
  • Energy
  • Agriculture

Depending on your risk mitigation strategy, parametric insurance can provide a cash infusion directly after a catastrophic event and tide you over while you’re waiting on additional claims. 

Parametric solutions for hard-to-insure risks

Parametric insurance can be a solution for areas at increased risk for property damage and business losses due to catastrophic events like:

  • Hurricanes and typhoons
  • Tropical cyclones
  • Tsunamis 
  • Floods and mudslides
  • Wildfires
  • Droughts
  • Flash rains
  • Earthquakes
  • Tornadoes
  • Outbreaks, epidemics and pandemics
  • Digital supply chain disruptions
  • Cyberattacks

Parametric insurance pays you a stipulated amount based on a pre-defined event, like a flood. The event must be measured or declared by a neutral third party that the insurer and insured agree on. 

When an event reaches a recordable measurement, the agreed-upon data source verifies the measurement that triggers your policy. Such measurements include: 

  • Wind speeds
  • Rainfall levels
  • Water levels
  • Wave heights
  • Days without rain
  • Earthquake shakes or shears
  • Fire burn radii
  • Lack of wind that reduces the energy output of wind turbines
  • Cyberattack effects on productivity

A parametric insurance example

Say you have an international company with several offices and manufacturing plants. A couple of your properties are difficult to insure because of their locations: a manufacturing plant in Florida (hurricanes and floods) and an office in Alberta (wildfires). Rather than maintaining several additional policies with lower limits than you require, you obtain parametric insurance. 

You supplement your existing business insurance with a parametric policy that covers your Florida and Alberta properties using data points provided by agreed-upon third parties. Your policy pays out based on the data, not the value of the loss:

Location Insured event Event trigger Agreed data source Policy payout
Florida Hurricane Winds 85 to 110 mph National Hurricane Center 25%
Florida Hurricane Winds 111 to 130 mph National Hurricane Center 40%
Florida Hurricane Winds exceeding 160 mph National Hurricane Center 100%
Florida Rainfall or flooding Rainfall exceeding 12 inches in 24 hours National Weather Service 100%
Alberta Wildfire 50-mile radius Satellite imagery burn area 100%

The downside of parametric insurance

According to the National Association of Insurance Commissioners, parametric insurance eliminates the claims adjustment process, allowing money to reach policyholders much faster. But there is a downside: basis risk. Basis risk occurs when the data used to model a trigger event fails to capture all the risk elements, resulting in more losses (and more expenses) than the original model predicted.

But artificial intelligence has made it possible to get granular. For example, farming models may need to be adjusted if plant types change, making them less tolerant to droughts. 

If you’re concerned about basis risk resulting in an underpayment, you may opt for a higher premium that biases risk toward overpayment. You can get as granular as you need in a policy. Some insurance companies may have experience or specialty areas, but that depends on the available relational data.

Parametric insurance isn’t a new concept

According to the data company LexisNexis, parametric products have existed since the 1990s. They evolved from catastrophe bonds (aka “cat bonds”) developed after Hurricane Andrew and the Northridge earthquake. Sometimes a catastrophic event can be so costly that it renders an insurance company insolvent. Cat bonds are insurance for the insurance companies: They offload the companies’ risk to investors. 

Parametric insurance opens opportunities to firms that can tap and source reliable data. Years of historical records can create indices that correspond to financial losses. 

Smart contracts, blockchain and parametric insurance

Data points and measurable thresholds are the languages of smart contracts and blockchain technology. Smart contracts are programs stored on a blockchain that run when predetermined conditions are met, similar to automated workflows. But because parametric insurance pays out based on event severity triggers instead of event damage assessments, smart contracts could hasten the funding period. A smart contract could manage a workflow to process a claim, like requiring third-party data verification, signatures and fund transfers.