Parametric insurance, delighting customers and carriers

Traditionally associated with natural catastrophes, agricultural risks and other major events like pandemics, parameter insurance is on the rise and seeing its scope of application widening. An increasingly connected world and the data thereby generated constitute a favourable turmoil for the development of parameters to be used to trigger insurance covers of existing and new risks.

In a nutshell, parametric insurance – also called index-based insurance – may be described as financial protection against a risk whose occurrence is associated with an event that may be detected and measured by predefined parameters or indexes. The event will trigger a claim when the associated index reaches or surpasses predefined levels.

The parameters agreed upon and defined by the client, the carrier and the broker determine the policy. They need to correlate with the underlying risk they seek to cover and be measured by reliable independent sources and/or institutions.

Examples of trigger indexes include:

• Number of infections during a pandemic
• Earthquake magnitude and shake intensity
• Hurricane wind speed
• Flood water levels
• Market index
• Crop yield
• Power outage
• Reported data breaches

While the risk covered is usually the loss incurred by the direct damage caused by an event – like earthquake, floods, hurricane, drought, … – it may also be a non-damage business interruption type risk, regardless of the tangible or intangible nature of the loss.

Neither better nor worse, parametric insurance complements traditional insurance in one or two ways. It is better suited for specific risks for which getting financial protection is often hard or impossible because of the magnitude of the potential losses and/or the difficulty in assessing them. It may also be combined with traditional repair-based insurance and fill the protection gaps left by elements such as deductibles, excluded perils, scarce capacity, or pure financial risks where the insured has no control over the underlying asset – like contingent business interruption for instance.

Such as traditional insurance may not cover all the damage caused by an insured event if the object of the policy is not correctly evaluated or defined, parametric insurance may be insufficient if the loss incurred is not adequately correlated with the chosen parameter and the threshold set. This is called the basis risk. For example, if an earthquake hits a region, causes damage but is of a magnitude that is inferior to the level set to trigger the claim (i.e. a magnitude of 6.5 on the scale of Richter when the trigger is set at 7).

While customers may be happy to get insurance coverage for risks that would otherwise be unprotected, it is just the first reason for their contentment. The mechanism of parametric insurance is much simpler and more streamlined than traditional insurance in many aspects.

Underwriting is simple and bespoke.

The indemnity of index-based insurance is the payment of a predetermined sum of money when a predefined index is reached or surpassed, once the triggering parameter and values are agreed upon, the contract wording is straightforward and close to an “IF-THEN” statement. It is hence stripped from the potentially complex assessment of an existing situation and associated terms and phrasing related to inclusions and exceptions. Quotation and enrolment are thus streamlined, and efficient, and provide a good experience to both the client and insurer.

As the underwriting process is more efficient and both parties are privy to the same relevant data about the probability of a risk happening, the insurer may more easily and with more confidence determine the rate to apply and turn pricing more competitive.

Still, it is in the moment of truth that customers appreciate parametric insurance most. Once the covered event occurs, meets or exceeds the predefined parameters and is confirmed by the independent designated entities, the conditions of the trigger are fulfilled and the pay-out may take place. Whereas in traditional insurance a claim needs to be documented and the loss or damage assessed before any indemnity reaches the insured, the pay-out of parametric insurance may happen instantly. Instead of having to wait long, sometimes up to 18 or 24 months in the event of natural catastrophes, insured of index-based insurances receive the promised amount, when they need it most, in a matter of days. This rapidity in claims handling is often critical and may determine the continuity of business – in the case of SMEs for instance.

While delighting customers, index-based insurance further charms carriers. Since the amount of payment is unaffected by the total loss, the insured still has an incentive to minimize losses, reducing the insurer’s exposure to moral hazard. The risk of insurance fraud is also reduced or inexistent for larger contracts because payment is standardized, and the event is large-scale and independently verified.

By increasing speed and certainty to deliver an outstanding customer experience, insurers please their customers, which builds trust and loyalty. On top of complementing traditional insurance products, parametric insurance solutions can achieve things that are not possible otherwise on an actual loss-sustained basis. Doing so they push the envelope of insurability, eliminate all complexity of a loss investigation process and give customers confidence when it comes to liquidity and speed of pay-out.