What is parametric insurance?

Updated 10- 11-2023

If there’s anything that recent global events have taught us, it’s that new and emerging risks can develop quickly, resulting in unprecedented losses and damages. In this constantly evolving risk environment, insurers are pressed to find creative and innovative ways to provide clients with adequate protection.

Enter parametric insurance. 

This type of insurance product has been gaining traction around the world in recent years. It has been described by some industry experts as “an elegant solution for risk-transfer concerns.” It is also lauded as an attractive alternative and enhancement to some traditional insurance policies.

Insurance Business digs deeper into this innovative insurance solution in this article. We will discuss how parametric insurance works, what its advantages and drawbacks are, and what lies ahead for this rapidly developing insurance product.

This piece can prove useful for both insurance buyers and brokers wanting to learn more about this type of policy. Read on and find out everything you need to know about parametric insurance in this guide. 

What is parametric insurance?

Parametric insurance, sometimes referred to as index-based insurance, is a type of policy designed to cover the likelihood of a predetermined event happening instead of compensating for the actual losses. Under this arrangement, a pre-agreed payment for a claim is guaranteed upon the occurrence of a triggering event.

“Broadly, it’s an insurance program that is triggered, and/or paid very simply using an index rather than words,” explained Steve Harry, senior vice-president at Marsh Risk Analytics.

Here’s an example in travel insurance. Let’s say you purchased a parametric travel insurance policy before making a train journey and your train is delayed by X amount of time. If the delay time of X – two hours, for example – falls within your policy’s parameter, you will receive an automatic and predetermined payout. This parameter is also referred to as the index threshold.

How are parameters or index threshold determined?

A parametric insurance policy has two key elements, which dictate its scope and premiums, and the conditions for which the policyholder can receive compensation. These are: 

1. Triggering event

For something to be considered as an insurable trigger, global reinsurer Swiss Re notes that it must meet two key criteria:

• It must be fortuitous, meaning it’s accidental.
• The insurer must be able to model it.

Coverage is triggered if predefined parameters are met or surpassed. But these must be measured through an objective parameter or index related to a particular exposure. These indices are often from an independent, third-party source. This is to remove any potential conflicts of interest and ensure transparency regarding the data used.

The table below lists some indices that parametric insurance providers use to measure insurable triggers.

“It’s important that neither the risk taker nor the insured are able to influence the event or its reporting to avoid moral hazard,” Swiss Re explained. “This is why indices around weather and ‘Acts of God’ are so popular in parametric insurance.”

2. A payout mechanism

The insurance company and policyholder must have a pre-agreed payout if a certain index threshold is reached or exceeded, regardless of the actual physical losses. For example, the insurer and the insured agree on a $30-million payout if a category 5 tropical cyclone strikes a defined geographical area.

The threshold for the trigger is usually set so that it aligns with the policyholder’s risk tolerance. Continuing from the example above, the insured might have adequate risk mitigation in place to deal with anything up to a category 4 tropical cyclone. But for storms above this category, they have opted for an alternative risk transfer solution in the form of a parametric insurance policy.

Parametric insurance means “policyholders get paid without having to go through a relatively lengthy insurance claim and loss adjustment process,” explains David Mäder, head of sales and delivery for P&S solutions at Swiss Re. Learn more: https://t.co/TCxXyVhFLJ pic.twitter.com/onjRRgmYFz

— Swiss Re (@SwissRe) November 19, 2021

What is the difference between traditional insurance and parametric insurance?

The insurance claims process is one of the most exciting and attractive parts of a parametric policy. Traditional indemnity claims can take months or years to solve, depending on the loss adjuster’s assessment and the complexity of the loss.

A payout when a parametric policy is triggered, meanwhile, can be sent within four weeks.

There’s no need for loss adjustment in parametric solutions, as long as the trigger or index is established. This is normally done by a third-party agent such as a national earthquake center or a weather agency.

The table below details the key difference between traditional insurance and parametric insurance.

Traditional insurance vs. parametric insurance

Source: Swiss Re Institute

Jargon buster: Basis risk

One of the most common misconceptions about parametric insurance is that basis risk exists mostly in this type of policy. The fact is, basis risk is present within all types of insurance structures.

In traditional indemnity insurance, basis risk comes in the form of insurance deductibles, sub-limits, and policy exclusions. This can result in a mismatch between the insured’s coverage expectations and the actual compensation paid under the policy.

In parametric insurance, basis risk occurs when index measurements don’t match the insured’s actual losses. While basis risk can’t be fully avoided, especially in index-based insurance, it can be mitigated with the use of more complex parametric structures. These include staggered payouts and double trigger events.

An insurer, for instance, can offer partial payouts for lower magnitude earthquakes and progressively increase the payouts for stronger earthquakes.

What are the advantages of parametric insurance?

Parametric solutions are not designed to be standalone insurance policies. Rather, they exist to fill protection gaps left by traditional insurance programs. Still, parametric insurance offers a range of benefits:

• Ease of pricing: Because parametric insurance offers fixed payouts based on the probability of a trigger, insurers can calculate premiums with a high level of certainty. This is especially crucial for low frequency but extreme events. 
• Simplified underwriting: And because parametric solutions are easier to price, this also reduces the time and information insurers need to underwrite a policy. 
• Customized policies: Parametric insurance is designed to cater to tailored requirements. These include coverage limits, term lengths, and conditions for payouts.
• Better customer experience: The speed and transparency that parametric policies bring enable insurers to provide customers with better customer service. This in turn builds loyalty and trust.
• Faster settlement: Because insurers base payouts on an index, this results in quicker resolution of claims. Parametric insurance payouts are usually sent within 30 days.

What are the drawbacks of parametric insurance?

In its recent analysis of the parametric insurance space, data analytics insurtech InsTech identified four challenges holding back the segment from wider adoption:

• Lack of education and awareness: The survey revealed a general lack of understanding from customers and some retail brokers about how parametric solutions work. This is particularly prevalent among those used to purchasing/selling traditional indemnity insurance.
• Basis risks: Parametric insurance is often viewed as having large basis risk, which prevents many clients from purchasing such policies.
• Cost of capacity or distribution: Distribution and insurance capacity costs are typically high for most insurance products. This has a direct impact on premiums.
• Regulation or fraud concerns: Because insurance laws have been designed with traditional indemnity insurance in mind, parametric solutions remain mostly unregulated. Fraud concerns are also discouraging customers from taking out coverage. This is despite triggering events being largely based on third-party data, which makes fraudulent claims almost impossible.

Here’s a summary of the pros and cons of parametric insurance.

Is parametric insurance expensive?

Parametric insurance is designed to complement traditional insurance, not replace it. Parametric solutions can only be purchased as add-ons to a standalone policy. While adding this type of coverage to standard policies can raise your premiums, it can lower the total cost of risk if used correctly.

Which clients are best suited to parametric insurance?

As mentioned, parametric solutions are not designed to be standalone insurance policies. Rather, they exist to fill protection gaps in more traditional insurance programs. For example, a client with very high deductibles or multiple exclusions on their policy may want to enhance their risk transfer with some parametric insurance.

“Buyers are now more sophisticated in the way that they look at their insurance, and they understand some of the limitations of a conventional insurance policy,” Harry explained. “Some people like the uncertainty that parametric insurance gives them, in that they can always argue about a policy contract, and other people like the certainty that an index-based product would give them.”

The scope of parametric insurance solutions is growing. Initially, they only really covered natural catastrophe risks, earthquake, and weather exposures. The industry is now making great strides around non-physical damage business interruption losses.

A commercial client might lose a certain amount of income over a period, which could trigger a payout without an identified event like a storm or an earthquake occurring. This will open the possibilities of parametrics to more and more clients.

Why should brokers be interested in parametric solutions?

It’s another tool in their toolbox. The goal of the broker is to transfer as much of a client’s risk as possible to provide peace of mind and business and life continuity. If a broker can place a strong policy and enhance that by filling any coverage gaps with a parametric solution, they can offer a more holistic risk transfer service.

Where should insurance brokers and risk managers start in looking at parametrics?

When considering parametric solutions, brokers need a deep understanding of their commercial client’s business model. The data demands of parametrics are more complex and because the cover tends to be wider, it can be more expensive.

“For risk managers [dealing with insurance brokers], taking the time to understand their firm’s ability to withstand future ‘shocks’ and gaining the support of the board are crucial first steps to incorporating parametric insurance solutions into their overall risk management strategy,” Harry noted.

Put simply, before purchasing a parametric policy, brokers and their clients need granular understanding of the loss exposures in play and the client’s economic ability to withstand future losses.

What does the future hold for parametric insurance?

As risks evolve and insureds look for more innovative ways to transfer their risk, parametric insurance solutions are likely to gain in prevalence.

With the level of support given to parametric insurance by governments around the world, regulators and lawmakers are expected to support and encourage the responsible roll-out of parametric insurance.

“With continued support and increased understanding, parametric insurance can fulfil its vast potential and alongside traditional insurance and other novel forms of risk transfer, play a key part in closing the protection gap,” noted Nigel Brook, partner at law firm Clyde & Co.

Parametric insurance can also serve as an important tool for businesses to manage their risks. If you want to find out more about how insurance can help businesses navigate difficult times, you can check out our comprehensive guide to business insurance.

Is parametric insurance a worthwhile investment? Do you have experience with parametric solutions that you want to share? Feel free to share your thoughts below.