As everything from hurricanes to cyberattacks cause ever-increasing losses for businesses, insurance carriers look for new ways to provide coverage while also reducing their risk and maintaining financial solvency. Parametric insurance is one tool in their toolkit that’s becoming increasingly common.
Parametric insurance to the rescue
During the 2021-2022 agricultural season, the country of Madagascar was plagued by extreme drought conditions. With little to no rainfall, farming communities across the country watched helplessly as their fields dried out and plants began to die.
Luckily, they didn’t have to struggle for long. Soon after the damages of the ongoing drought were realized, the African Risk Capacity Group and the African Development Bank presented the Madagascan government with a $797,049 insurance payout check. These funds immediately went to the communities most affected by the drought and helped feed thousands of vulnerable people.
The payout came from a parametric drought insurance policy Madagascar took out to protect its people from the ongoing effects of climate change. And the Madagascan government isn’t alone in its thinking. As extreme conditions become more common and more severe, countries and communities all over the world are finding relief in the face of disaster with parametric insurance policies.
What is parametric insurance?
Parametric insurance, sometimes called index-based insurance, offers policyholders pre-specified financial protection when a particular parameter is met. Every parametric insurance policy must include a predetermined payment amount, parameter, and third-party verifier.
In the case of Madagascar’s drought, the amount of payment ($797,049) and the parameter (delayed rains) are clearly defined. Once a third-party was able to verify the delayed rains, the payout was given to the Madagascan government to direct towards those most affected.
Similarly, different parametric policies may pay out a specific amount for events like a flood, a fire, a cyberattack, and more.
How is parametric insurance different from a traditional insurance policy?
While traditional indemnity insurance policy payouts are determined by the amount of loss incurred (up to a policy’s limit or maximum), parametric insurance policy payouts depend on the magnitude of the event, assuming the event happens at all. When it comes to payment, indemnity insurance seeks to reimburse the insured for their loss while parametric insurance offers a previously agreed upon amount for a specific event. It actually doesn’t matter how much the policyholder actually loses from the event. A flood could cause $1,000 of damage or a million, but if someone has a policy that pays $250,000 for a flood, then that’s what they’ll get.
One of the biggest differences between parametric insurance and traditional insurance is the speed of recovery. Because parametric insurance payments are pre-determined, there’s no need for claims adjustment. This makes the claims process smoother and settlement quicker, allowing the affected party to receive their payout much faster than with a traditional insurance policy. Quicker claims also lead to greater customer satisfaction, which is something the insurance industry can use more of.
Why would someone use parametric insurance?
Parametric insurance is not designed to fully replace traditional indemnity insurance. Rather, its purpose is to complement traditional insurance policies by filling gaps in protection and speeding up recovery time.
This type of insurance is especially helpful for risks that are typically underinsured, like in the case of a natural disaster. For example, decreased ocean water levels could have catastrophic consequences for shipping companies. While a decreased water level causes little to no physical damage, the business interruption it causes can be just as harmful to a shipping company’s bottom line. A parametric policy that triggers when the water hits a certain level can help these shipping companies protect against any loss in revenue.
What are the benefits of parametric insurance?
As previously mentioned, parametric insurance eliminates the claims adjustment process, meaning policyholders can receive payment a lot faster. While indemnity insurance claims can take months or even years to settle, without the adjustment process parametric claims can be completed within weeks. This is a huge benefit for anyone whose property has been damaged in a natural disaster and needs to begin rebuilding as soon as possible.In fact, payments from a parametric insurance policy are almost four times as effective at accelerating disaster relief and minimizing losses as the same payment made less quickly.
How does parametric insurance benefit insurers?
Parametric insurance offers significant benefits for policyholders, but it can also benefit insurers. One way this happens is by reducing moral hazard: the idea that insurance promotes risky behavior for personal gain. With a parametric policy, the payment amount is agreed on in advance. This means increasing their risk does nothing to increase the amount an insured will receive in the event of an accident reducing the chance of moral hazard.
Parametric insurance policies also offer insurers an additional sense of security. The standardized payment and third party verification can make insurance fraud less of a problem. Plus, insurers can more easily quantify and predict their maximum potential payouts, versus the potential for nearly-infinite payouts if a major disaster impacts every one of their policyholders with traditional indemnity insurance at the same time.
What are the drawbacks of parametric insurance?
Parametric insurance is not without its downsides. The most obvious is basis risk, or the difference between expectation and outcome. What if a loss occurs without triggering the parameter? What if the magnitude of an earthquake didn’t reach the trigger point for payout, but still caused a significant amount of damage? Or what if the parameter was triggered, but the loss grossly outweighs the payout? Insurers have to balance the amount of money paid for different parameters, or risk losing consumer confidence on one end, and paying out more than their premiums can support on the other end.
The industry’s best chance at combating these drawbacks is with technology. As geographic modeling technologies advance and scientists get better at predicting things like wind speed, rainfall, and weather changes, basis risk should become less of a problem.
Why is parametric insurance becoming more popular?
With the world still reeling from the effects of a global pandemic and growing increasingly aware of climate change, parametric insurance is stirring up a discussion within the insurance sector. With natural catastrophes causing an estimated $105 billion in global insured losses, some experts think parametric insurance is the answer to tackling the challenge of insuring natural and epidemiological disasters for years to come.
There’s also the fact that with parametric insurance, claims resolution is just about automatic. By eliminating the adjustment process, insurance professionals save time, money, and valuable resources.
How is parametric insurance regulated?
As it stands, there are currently few regulations specific to parametric insurance policies. In general, they follow the same regulatory framework as traditional policies do. However, this can create hurdles in the recovery process. In jurisdictions where policyholders are required to prove that a loss has occurred, payment can take longer, defeating the main purpose of choosing a parametric policy.
Parametric insurance provides assistance when it matters most
Hurricanes, earthquakes, climate change, a global pandemic. These events are unpredictable and the damage they cause can leave individuals and businesses struggling to get back on their feet. Parametric insurance provides a speed of payout not possible with traditional indemnity insurance. These quick payouts provide relief and help communities heal and rebuild in the aftermath of disaster.
At the same time, the increasing frequency and severity of catastrophic events is causing many insurers to pull out of high-risk markets, leaving consumers with very few (if any) options to insure their homes and other valuable assets. Parametric insurance may provide an option that allows insurers to offer some level of coverage to people in disaster-prone areas while protecting themselves from insolvency.
Claims adjusting isn’t the only slow process the insurance industry struggles with. Producer onboarding and ongoing license compliance can slow things down and cost money. If you’re looking to speed up processes and increase efficiency at your agency, carrier, or MGA see how AgentSync can help.