When we think about the impact of pandemics or climate change, insurance isn’t the first thing that comes to mind. Yet, insurance plays a critical role in protecting people and businesses from the impact of these very events. Today, the Covid-19 pandemic and the growing consequences of climate change are stirring up discussion in the insurance sector. Many experts are citing parametric insurance as a way to tackle the challenges that come with insuring natural and epidemiological disasters.

For insurers, natural disasters and worldwide phenomena like pandemics have historically been incredibly difficult to model. Some limit their coverage of these events, as a result, or hike up their premiums. As such, businesses often have a difficult time acquiring insurance for these types of events. According to SwissRe, natural catastrophes caused an estimated $105 billion in global insured losses in 2021. This is the fourth-highest amount since 1970. Perhaps even more astounding is the fact that research by MunichRe states less than half of all natural catastrophe losses are even insured to begin with.

While parametric insurance is by no means a new concept, it is rising in popularity. In this article, we look at how exactly parametric insurance works, what the benefits are, and how it fits in comparison to traditional insurance policies.

What is parametric insurance?

Parametric insurance is also known as index-based insurance. It offers financial protection for events that have been previously defined by the insurer and the insured. Although it emerged in the 1990s, it remains largely unknown or misunderstood today. However, this is changing. Today, many claim parametric insurance is a useful solution to insure events resulting from climate change.

Measuring the losses incurred from climate change (floods, droughts, earthquakes, etc.) can be challenging with traditional insurance methods. Most importantly, when a disaster occurs, measuring the losses is a process that can take an extensive amount of time and risks lacking accuracy. This can have a detrimental effect on businesses. SMEs are especially at-risk in these situations.

Parametric insurance takes a different approach to covering losses. The insurer and the insured define an event and a threshold point that triggers a payout. While this is particularly useful for natural disasters, it can be used for various other events: market indices, reduced crop yields, data breaches, etc.

In the most simplified way, we can say there are three key steps in parametric insurance:

• Create a bespoke contract that includes pre-defined events such as an earthquake, a flood, critically low crop yields, etc. Define the parameters that will trigger the policy and the amount the insured will receive if said parameters are met or exceeded. These calculations are based on risk modelling that uses historical data and real-world measurable data (e.g. amount of precipitation or wind speed measured by weather stations).

• Monitor the parameters in question to detect when the threshold has been reached or exceeded. A third party determines the intensity of the event to avoid any conflict of interest and ensure transparency.

• If the threshold is reached, the pre-defined indemnity is automatically provided to the policyholder. It can be in full, or it can be dispersed in percentages, based on what the policy had defined. This happens within a short span of time. Technically, the funds can be provided as soon as the next day.

For example, a policy could state that $10 million is issued to the insured if a magnitude 7.5 earthquake occurs in a designated region. The choice of this trigger point (7.5 magnitude) is based on an assessment of the likely impact this event would have and the maximum impact the business in question could reasonably withstand. The probability of a magnitude 7.5 earthquake occurring is then part of the risk modelling that helps determine the insurance premium.

In conclusion: in traditional insurance, payment is triggered by the actual loss of or damage to a physical asset; in parametric insurance, payment is triggered by an event occurring and exceeding a parametric threshold.

What are the benefits of parametric insurance?

Faster payout

Parametric insurance policies enable quick payouts. This can be critical for businesses to recover from a damaging event. Furthermore, the insured knows this payout is guaranteed as it is based on objective and predefined criteria. Did the event set out in the policy occur? Did it reach the level/threshold also defined in said policy? If the answer to both these questions is yes, then a payout will occur.

This also means that if the insured doesn’t actually incur any damage, or incurs very minimal damage, the payout defined in the policy will occur nonetheless. For traditional insurance, once a disaster has occurred, the insured has to prepare documentary evidence of the damages incurred and often wait long periods of time for an expert to come measure the losses to be covered. This process can take a significant amount of time. With parametric insurance, this type of documentation or evidence is not necessary.

Faster payouts are also a benefit for insurers. Indeed, parametric insurance policies help eliminate the unknown for them. Once an event happens, they can determine precisely how many payouts will occur as a result.

On a larger scale, faster payouts can also prevent a situation (humanitarian, disease outbreak, etc.) from worsening any further. For example, if a specific trigger was reached in a food crisis, funding could be disbursed to NGOs and civil society organisations to respond quickly.

Customisation and flexibility

By definition, parametric insurance policies are custom-made, with tailored requirements. This customisation better reflects the policyholder’s needs and takes into account their risk assessment. Furthermore, there’s flexibility in terms of the time range. A policy can be valid for a few months or several years. In terms of the payout, the parties can set out percentages based on the magnitude of an event. For example, a category 5.0 earthquake could disburse 50% of a defined payout whereas a category 7.0 earthquake could disburse 80% of this defined payout.

All in all, both the insurer and the insured have the flexibility of defining a custom agreement with parameters they fully understand, that ideally would match both of their needs and expectations.

Lower premiums

Traditional insurers face significant costs (loss adjusters, claims teams, legal support, etc.), which leads them to put high premiums. Parametric insurers don’t require the type of support that creates these costs since they don’t function on the same premise as traditional players. This helps them offer lower-cost premiums to their clients.

Lower premiums is a significant benefit for SMEs who don’t have the necessary funds to pay for traditional indemnity insurance.

What are the challenges of parametric insurance?

It’s important to note that parametric insurance doesn’t replace traditional insurance policies. Neither system is better than the other, instead they’re complementary tools. Indeed, parametric insurance can help fill some of the protection gaps experienced with traditional policies.

Since parametric insurance is a trigger-based policy, rather than an indemnity-based policy, there are some drawbacks. If the policyholder faces greater losses than the predetermined amount, they will have to bear those costs alone or through a different policy. Indeed, while basis risk exists with all insurance structures, it is frequently cited as a downside of parametric insurance.

Closely linked to basis risk is the quality of the risk assessment. As with most insurance policies, the accuracy of the risk assessment data is of utmost importance. By adequately predicting the losses incurred by an event, insurers and policyholders can avoid significant mismatches between losses and payments.

Market drivers for the years to come

Considering the continuous effects climate change is having on our planet, parametric insurance will likely continue to rise in prominence. The pandemic has also heightened businesses’ understanding of how outside events can drastically impact their survival. They’ve discovered how many traditional insurance policies simply don’t cover pandemic-related losses. Indeed, lawsuits made the headlines as businesses found out insurers wouldn’t cover pandemic claims, arguing the virus did not damage any property.

Furthermore, parametric insurance also benefits from the continuous improvement of digital tools to predict weather events and outcomes. Indeed, hazard modelling is benefiting from more accurate measures from weather stations and satellite-captured data. Startups worldwide are providing data collection and analysis tools powered by AI, machine learning, computer vision, and other powerful technologies.

Lastly, the insurance market is hardening, and has been for some time now. This means demand for insurance is high but there’s a lower supply of coverage. As a result, premiums rise and underwriting becomes more stringent. A hardening market presents opportunities for insurtech startups and other innovative players to emerge as promising alternatives.

Startups and technology powering parametric insurance

Some of the technologies being used to enable and bolster parametric insurance include:

• IoT/sensor technology: to collect real-time data that helps establish the triggers of a parametric insurance policy and better assess probabilities

• Satellite imagery: to detect events and changes in real-time through detailed and comprehensive imaging

• AI, machine learning and deep learning: to analyse the data collected, deduce insights and anticipate events from it

• Blockchain: to create smart contracts that will automatically trigger claims payments when a threshold is reached

It’s partly thanks to advances in these technologies that parametric insurance is becoming increasingly appealing for climate-related events. Sensor technology and machine learning algorithms paired together enable real-time monitoring of conditions such as rainfall. This can then determine the probability of an event occurring, based on the data collected. It also provides immediate access to objective evidence that an event has occurred (rising water levels detected, a certain number of days reached without any rainfall, etc).

This means that, on the one side, the insured can better protect themselves. On the other side, the insurer can define well-suited contracts with a powerful assessment of risks and probabilities for a threshold to be reached or for an event to occur. Simply put, for the insurer, knowledge is power, and new technologies are enabling access to the highly reliable data they need.

To illustrate how these technologies are being used for parametric insurance, let’s look at some recent success stories in the startup ecosystem:

FloodFlash, a UK-based startup, recently raised $15 million. The startup has developed a parametric flood insurance offer that enables its clients to set a flood depth and payout amount to receive a personalised quote. Using sensor technology, the startup gets an immediate notification when an agreed-upon flood depth has been reached. The settlement is typically sent out within 48 hours.

Descartes Underwriting, a startup based in France, raised €107 million in January 2022. The startup uses satellite imagery, sensors and AI to detect events (natural catastrophes, environmental hazards, etc.) for its climate risk insurance. The insured then receive their pre-established settlement within a matter of days.

Stable, a UK-based startup, raised $46.5 million at the end of 2021. The startup offers index-based insurance to protect businesses from volatile commodity prices – a growing issue today. Stable lists thousands of third-party indexes to choose from, for commodities that cannot be hedged today on the futures market. Settlements are immediate, based on a commodity’s price shift and a baseline index price.