Why parametric insurance policies pay off during catastrophic events

Why parametric insurance policies pay off during catastrophic events | Insurance Business

Why parametric insurance policies pay off during catastrophic events

Amid an insurance protection gap that’s growing wider over recent decades, and natural catastrophes that are exacerbating the problem, due in part to the fact that people have trouble accurately quantifying the level of risk they face, an innovative coverage solution is making a name for itself.

Parametric insurance is based on the development of an index, rather than the actual loss to a policyholder. When a certain value is exceeded on the index, that triggers coverage and claims are paid out to the policyholder.

“It’s formula-based, it is transparent, and it does not involve a claims settlement or claims adjustment process,” explained Thomas Holzheu, Swiss Re’s chief economist for the Americas. “As opposed to traditional insurance, where you have a defined insured asset, you have a definition of what an insured event is, and then you have a claims process where the actual loss of the insured gets assessed by a claims adjuster and then is paid out accordingly.”

Read more: What is parametric insurance?

The principle of parametric insurance is that an insured receives a payout that is tied to pre-defined index criteria being met. For example, a parametric weather policy for farmers could be based on an index measuring the amount of rainfall during a storm, which would then be triggered if precipitation exceeds a certain level in a defined area. Wind speeds and the degree of ground shake during earthquakes also often underpin the indices used by parametric insurance. While crafting the policy, an insurer can simulate a specific catastrophe and determine the amount of damage it would cause based on severity and the insured’s at-risk assets, which in turn helps to identify the resulting compensation for the insured should the event happen.

In the case of a large utility company that controls an electrical grid, if winds cause power outages and damage to powerlines that requires the rebuilding of the grid, it can be complicated to cover this with a traditional insurance policy because the assets likely won’t be reconstructed in exactly the same way. Meanwhile, with a parametric policy, the costs to rebuild the grid and improve upon it to make it more resilient for the next windstorm would be factored into the policy and once a certain wind speed is reached, the company sees a payout.

“The claims settlement would’ve been very complicated within a traditional insurance cover, as opposed to a parametric policy where they get compensated for the financial impact and they don’t need to differentiate between what [costs are associated with] rebuilding, improving, or upscaling the grid,” said Holzheu.

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Parametric insurance solutions tend to act as enhancements to traditional policies and have gained popularity in the energy sector, where there is an intersection of catastrophe-related losses and market risk. As a result, some of the parametric policies for these companies have a ‘double trigger,’ according to Holzheu, where coverage would be triggered based on the combination of a natural event occurring at a time when the company is also exposed to swings in energy prices.

Weather events don’t necessarily have to be stormy to trigger parametric policies. For a solar company, claims could be paid out if there isn’t enough sun as measured by a ‘sunshine’ index. The same goes for a wind power company that needs strong winds, or a hydro company that relies on a certain level of rainfall.

As for the protection gap, parametric solutions have helped to reduce the spread when it comes to catastrophic events, weather-related or not.

“They help to cover these risks that are otherwise difficult to insure. If you deal with a new type of situation – a new type of business risk or exposure related to a risk that can measured with an index – it’s difficult for insurance companies to underwrite this if it’s relatively new and you don’t know yet precisely how the client is affected by it,” said Holzheu, adding that with parametric policies, “You don’t need to have as much insight into the economics of the client. It takes out some of this uncertainty and ambiguity about how a new peril will play out.”