Published on 11 January 2022

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Parametric Insurance: Transforming Risk Mitigation

Published on 11 January 2022

Parametric coverage is nothing new, having emerged as an important insurance and reinsurance tool alongside the early development of insurance linked securities in the mid-1990s, but today the product is gathering pace as a solution for a range of under-insured and uninsurable risks.

Parametric coverage is the ‘new’ insurance phenomenon that is rapidly gaining traction as a solution for risks previously considered either ‘uninsurable’ or with limited coverage available in the traditional market.

In truth, there is nothing new about the notion of parametric insurance. The use of parametric triggers has been around for nearly three decades, but has more commonly been associated with the alternative reinsurance sector – for instance, in structuring catastrophe bonds for earthquake or hurricane risks.

But the application of parametric triggers to indemnity products rather than financial derivatives is growing in popularity, with parametric insurance solutions appearing across a range of scenarios.

 

Transforming insurance buying

Parametric insurance differs from traditional indemnity products in that pre-defined triggers are used to determine when a loss event has occurred and its value, rather than an adjustor determining the value of an insured’s loss and how much is covered by their insurance policy. These triggers are agreed between vendor and client prior to inception and linked to a trusted and verifiable independent third-party data source.

As a consequence, the product offers pricing based on modelled loss experience on historical geographical averages – for example using annual rainfall indices in a particular area, to determine a trigger for drought or flood events. - Such indices can be independently monitored and assessed by both the insured and insurers so that when conditions under the policy are met payments can be made quickly.

 

The growth of parametric solutions

No longer a niche reinsurance product, parametric solutions can now be found throughout the (re)insurance chain, from deductible infills on primary programmes, through to excess of loss and quota share reinsurance placements.

At the same time, a wealth of increasingly granular risk data from the growing constellations of low earth orbit observation satellites, coupled with improved modelling methods and AI-driven data processing, mean that more accurate triggers for parametric coverage can be generated.

Growing interest in parametric covers also comes at a time when the insurtech space is booming and managing general agency/underwriting platforms (MGAs/MGUs) are increasing in popularity, providing more flexible options for distributing these products to both consumer and corporate markets via insurance products rather than derivatives, only accessible to larger more sophisticated insured’s or insurers. It seems likely that with new classes of business and risk areas coming on stream over time, parametric covers are clearly here to stay.

 

Pros and cons of parametrics

For prospective buyers of parametric solutions the benefits might not appear immediately obvious.

To begin with, parametric solutions are used in some cases to provide coverage where none has existed before, such as Non-Damage Business Interruption (NDBI) coverage in the construction market, or where client retentions are unacceptably high and introduce too much volatility to run unprotected on the balance sheet.

In addition, the pricing of parametric cover is focused on the indexed data linked to a specific peril and location rather than an insured’s overall loss history that traditional insurance solutions are dictated by.

“In essence, it doesn't really matter what the asset is, we're modelling the hazard,” says Simon Edwards, Technical Underwriter – Parametric Insurance, for Generali Global Corporate & Commercial. “Whether it's a car lot, a crop, or a solar cell, the rate on-line will be exactly the same, because it's the hazard at that location.”

Alesco’s Alternative Risk Transfer team added, “Whilst a Parametric might not be a suitable solution for all insured’s they should certainly be considered as a very useful tool when looking for a viable alternative to self-insurance.”

A key selling point for both brokers and buyers of parametric cover is also the increased transparency and efficiency of the claims process. Property catastrophe claims can take months, even years, to get paid, whereas parametric covers are likely to pay out within weeks of a loss – up to a couple of months at worst. Therefore, for some businesses the impact of a loss on cash flow may make a smaller parametric pay out more attractive in order get back up and running quicker.

 

Beware of Basis Risk

Of course, there are some downsides to parametric coverage, with concerns in particular around basis risk. Typically, parametric triggers should be highly correlated to a potential loss, but for perils where coverage is reliant on a higher degree of modelled data rather than precise indices, that basis risk will inevitably increase. Perhaps the most high-profile example of this situation is the World Bank’s Pandemic Bond which failed to pay out for the 2018 Ebola outbreak and has had a spotty record during Covid-19, leading the Bank not to renew.

 

Opening up new opportunities

The real game changer that parametrics offer is their ability to tackle new or challenging risk areas. Increasingly, it is not just weather risks for traditional property and construction portfolios that are benefiting from parametric solutions. According to Jonathan Charak, Emerging Solutions Director for Zurich North America, writing in a February blog post, a number of novel risks are being addressed by parametric coverage.

One of the more esoteric options is a ‘disgrace’ or reputational risk insurance, which uses predictive analytics to measure the impact of publicity generated by an unexpected incident or negative publication.

Another firm mentioned in Charak’s blog is Parametrix, which covers financial loss incurred through an interruption in services from third-party technology providers. With many companies increasingly dependent on cloud-based data and software solutions, coverage for outages is quickly becoming an essential component of risk management strategies.

There are also a number of parametric weather risk covers across the burgeoning renewable energy sector. From insuring physical losses such as hail damage to solar cells, there are also yield-based products that cover financial loss in the event of a drop in wind, sunshine or rainfall that could impact wind, solar and hydro power generation.

Other innovative products include cover for low river levels which could impact the operations of companies transporting goods by water. The cover is triggered when low river heights force freight handlers to transfer their cargo from barges to road or rail transport, incurring additional costs. And in the Caribbean and the Gulf of Mexico, the proliferation of Sargassum seaweed - which can end up covering beaches with an unsightly and malodorous carpet - has been a major issue for the tourism industry. Parametric solutions have been used to offset revenue lost through closing beaches and facilities, cancelled bookings, and reduced footfall. Whether addressing new risks that the traditional market has failed to get to grips with, filling the areas excluded from existing policies, or stepping into the gaps left by retreating cover from the primary market, parametric cover is fast establishing itself as a key component of the (re)insurance mix and should not be ignored.