Parametric insurance

Parametric insurance has been around for more than a hundred years, but its more recent incarnation dates to the 1990s.

Parametric differs fundamentally to conventional indemnity insurance in that there does not need to be an actual loss for a claim to be made and paid.

Under indemnity insurance the policyholder incurs a loss due to one or more of the covered risks – eg a loss due to property damage caused by flooding. With parametric insurance a claim arises when a trigger event occurs – eg rainfall exceeds a certain volume – with the payout being automatic and for a pre-agreed amount, regardless of whether there is an actual loss.

The trigger event has two parts. Firstly, there is a parameter that can reliably measure the risk that can causes a loss. So, in the example above, high volumes of rainfall can lead to flooding and potentially losses due to water damage. A rise in river levels would be an alternative measure for flood risk.

The second part is to then calibrate the parameter and risk – so what volumes of rainfall are associated with what losses. This then drives the pricing or premiums and claim payouts when the event occurs.

For the parameter to work it has to be trusted, have certainty and be reliable - ie it needs to be objective, transparent and independent. And good data is necessary to enable the link between the parameter and losses to be effectively modelled and calibrated.

Climatic events can lend themselves to parametric insurance as different types of climatic conditions have long been measured and there are many established scales or indicators: the Richer or Moment Magnitude Scales for earthquakes; UK storms likely to pose disruption or damage have been named since 2015 (Claudia most recently); days without rainfall can be used to measure the effects of drought; rising sea or river levels can indicate flooding.

But other events that may also lend themselves to this type of insurance and, as our ability to capture more data and measure more matters improves, so more events may come within scope: for example, train or airflight delays, systems outages, the duration of pandemic lockdowns.

The pros and cons of parametric insurance

The biggest advantage is certainty over the value of the claim payout upon the trigger event, and rapid payment of the claim. There is no need to submit a claim, no need for a loss adjustor and no potential protracted wrangling over whether the claim should be accepted and for how much. This can offer immediate peace of mind to the insured and enables funds to be rapidly deployed to alleviate any losses of the insured. Moreover, with technological advances and smart contracts the speed and efficiency of payouts can be further enhanced.

The most significant downside, however, is the potential disconnect between the value of the claim payout and the actual loss incurred. Because the value of the claim payout is pre-agreed it may not be sufficient to cover the actual loss, leaving the policyholder out of pocket. The flip side is that the policyholder in some circumstances may benefit from a claim payout without incurring an actual loss.

And so may not always be suitable – the FCA concern

The characteristics of parametric insurance mean it is suited to certain situations but not others. In this regard the product should be seen as complementary to, rather than a complete substitute to traditional indemnity insurance. The two types of insurance may also work in combination to provide more complete protection for a policyholder.

For example, parametric insurance is not necessarily a suitable product if individual asset protection is important, as the policyholder needs certainty the asset can be restored to its pre-claim status (whether through repair or replacement). An obvious scenario is the retail homeowner: they need certainty that their building cover will make good any substantial property damage, as otherwise there is a risk that they cannot afford to properly repair the property, to their detriment (in extremis an uninhabitable house). With a parametric policy the homeowner would face a risk that either the claim would not be triggered, or if triggered that that the payout is insufficient.

Moreover, a property can be exposed to a range of risks – flooding, fire, subsidence, damage caused by a break-in; and some of these may have multiple potential causes – flooding could be caused by external weather-related events (excessive rainfall), external man-made events (blocked drains), or internal events (a burst water pipe). Parametric insurance may be possible for some but not other of the risks, yet the policyholder wants cover for all; even remote events because of the severity of the effect if an event should occur.

On the other hand, when there is widespread damage as caused by natural catastrophes such as earthquakes or drought, parametric insurance can lead to monies being rapidly paid to the authorities (policyholder) to fund broad and immediate disaster relief efforts. There are a number of such initiatives that operate at a sovereign or regional level: eg the African Risk Capacity Group.

Some risks to the individual may also not suitable to parametric insurance because of the potential severity of the event (serious accident) or because individual behaviour is a factor, which is hard to measure or parameterise (bad driving). On the other-hand some personal risks may be suitable – a delayed flight.

Identifying the appropriate scenarios when to use parametric or indemnity insurance, or how to use in combination will be important to the FCA and whether insurance companies are treating consumers appropriately or fairly under the Consumer Duty.

The future

The parametric insurance market is expected to grow. Key drivers are the increasing frequency and severity of climate related events; and technological advances which enable us to measure ever more matters and capture more data and undertake more sophisticated data modelling.