How Parametric Insurance Is Reinventing the Industry


One of the major lessons of the Covid-19 pandemic is that we live on a volatile planet.  The pandemic has in part spurred consumers to look for coverage related to risks resulting from climate change, natural disasters, rapid urbanization, health crisis, or political unrest.

However, studies show that traditional insurance covered only 40% of the $140 billion of economic losses from natural and man-made disasters in 2019.

The challenge for the slow-moving insurance industry is to find ways to provide coverage for a rapidly changing risk environment. A new and creative approach to insurance is needed to help those affected recover their losses. Insurance buyers are actively searching for affordable insurance solutions that offer a fast claims resolution process.

Some carriers have introduced parametric insurance solutions as a creative alternative to traditional products. Parametric insurance (also called index-based insurance) has great potential to fill the gap left behind by traditional insurance. These index-based solutions are alternative risk transfer solutions that are gaining traction among leading insurers.

This type of insurance is called parametric because it pays out when a defined "metric" such as wind reaching a certain speed or an earthquake of a particular magnitude occurring in a specified location.  So, a parametric insurance policy doesn't address a specific loss or physical damage. Instead, it pays out a pre-defined amount based on a trigger event.

Let's go into more detail and find out why parametric insurance solutions are cited as the top product development priority for major North American and European carriers.

Defining Parametric Disaster Insurance

While traditional indemnity insurance pays out a claim based on the value of the loss suffered, parametric insurance policies pay out only upon the occurrence of specified events (for example, weather events). So, the amount paid out is not based on the cost of the actual loss incurred but rather on the size of the event — wind speed, earthquake magnitude, water levels, and amount of rainfall are the most common examples.

parametric insurance example

However, predetermined trigger events don't have to be weather-related risks; business interruption caused by problems in the supply chain can also be a trigger.

Different Components Of A Parametric Solution

Parametric insurance is elegant in its simplicity. A parametric insurance cover consists of two key components: a triggering event and a pay-out process. These two features determine the scope of the policy, pricing, and the conditions under which the insured receives financial reimbursement.

Let's go over the key features of a parametric insurance policy:

  • A predefined event taking place and reaching a certain size.
  • An independent, third-party source, providing the relevant information, is a crucial requirement for the parametric cover as the entire payout is based on this data. This removes any potential conflicts of interest and provides transparency to customers on the data used and the reliability of the product.

The National Oceanic and Atmospheric Administration or the United States Geological Survey would be examples of relevant third-party agencies. As a backup measure, there will typically be other third-party agencies that can provide accurate data if the primary agency is not functioning properly. For instance, a powerful earthquake damages the sensors of a relevant agency, which prevents it from reporting the official magnitude.

Together, these elements offer insureds a quicker claims process — the triggers are independently validated, which automates the payment.

A Quick Note On Parametric Insurance

Since payments are based on a triggering event and not on the actual physical damage, the amount paid out may be lower or higher than the actual loss. This is called basis risk and it's something that insurers need to consider.

Proof-Of-Loss is Required in the United States

The term "parametric" only refers to an event that initiates a pay out mechanism. Therefore, its application goes beyond the insurance industry. For example, other risk transfer products, such as derivatives, can be considered as parametric triggers.

To distinguish this type of insurance from gambling, regulators in the U.S. require "proof-of-loss." The insured has to prove that an actual loss had occurred before the payment is made. However, showing proof of a loss isn't necessarily cumbersome — U.S. regulators accept things like images taken with drones and text messages from customers.

So, the U.S. insurance market has found a workaround that preserves the main advantages of parametric solutions while adhering to regulatory requirements.

Advantages of Parametric Insurance Policies Over Traditional Policies

While parametric solutions may still be in their early stages, the ability to deliver automatic payment in a data-driven world helps it fill the gaps created by traditional insurance products.

Competitive Pricing

One of the challenges in insurance is setting appropriate rates.

In traditional indemnity, pricing the risk of a loss is not easy. Oftentimes the price set by traditional insurance is so high that no one buys it. This is the case with flood insurance today — conventional insurance is expensive with a slow and cumbersome payout mechanism.

Get Rid of Knowledge Imbalance

The insured generally has the benefit of having more information about their own risk than the insurance carrier. Parametric insurance policies remove this information imbalance and give the insurer a better understanding of the underlying risk exposure. Both parties are privy to the same relevant data about the chances of an event happening.

That's the reason why parametric insurance is becoming an appealing option to non-insurance capital providers because there no need for them to analyze the risk in their clients or their assets.

Also, one of the major benefits for insurers is that every parametric solution offers fixed liabilities.  As a result, insurance providers can calculate the total amount of liability with a high level of certainty. This is especially important for low-frequency but severe events.

Streamlined Underwriting

The ease of pricing offers another benefit — a simplified underwriting process. Since risks are priced based on the likelihood of a trigger, parametric insurance provides fixed and capped payouts. This gives insurance carriers the ability to generate more sales by reducing how much time and information is needed to quote a policy.

Innovative & Customized Insurance Policies

Conventional insurance policies generally use standardized phrasing. On the other hand, a parametric policy is a custom-built product with tailored requirements. This wording reflects the customer's specific needs, in line with their risk assessment.

A parametric insurance product is flexible — a policy can be valid for a few months to several years.

Also, a parametric policy might be designed to pay out 50% or 75% of a pre-agreed limit for a Category 3 hurricane and 75% for a category 4 hurricane.

So insurers have many different ways of customizing their parametric solutions.

Better Customer Experience

Parametric insurance combines speed and certainty to deliver an outstanding customer experience. Therefore, it increases the likelihood of insurers pleasing their customers, which builds trust and loyalty. The customer knows the exact amount to be paid and under which conditions.

The promise of a seamless payout mechanism contrasted with the tiresome process administered by adjudicators in traditional insurance is too good to ignore.  

Instant Payout

While determining actual physical damage with traditional covers can be both complex and slow — often taking weeks to months to settle — parametric insurance pays out in days of an event.

Instant payouts mean that policyholders don't have to use their savings or get a loan to cover their losses while they wait for the insurer to react

Provides Assistance When It Matters The Most

Quick payments play an especially vital role for victims of natural disasters.  Agencies that are responsible for disaster response benefit from receiving funds immediately because resources can be deployed quickly when it's most critical. United Kingdom's Foreign, Commonwealth & Development Office concluded that fast availability of funds improves disaster response and mitigates losses.

Major Carrier Offers Parametric Solutions

Lloyd’s has introduced a parametric earthquake insurance policy in New Zealand. The insurance giant wants to use parametric products to enhance coverage through simpler insurance products.

The policy automatically pays within days of an earthquake. Therefore, Lloyd's delivers affordable coverage and fast claims payments while meeting customers’ needs following an earthquake.

The Essential Tool for Creating A Parametric Insurance Policy

Parametric solutions are common in industries such as agribusiness and catastrophe insurance where triggers are easy to identify.

However, the hyperproduction of data is exponentially increasing the number of risks that can be covered by parametric insurance.

Insurtechs are offering consumers parametric insurance covers from different types of risk — covers include anything from flooding to a canceled flight or not enough snow on a winter vacation.  And financial reimbursement is instant!

Parametric insurance is a winning strategy because this type of insurance gives customers the ability to choose the protections they want. And using objective data sources to churn out premiums in real-time with a quick payout scheme gives insurers the ability to meet consumer expectations.

Building Parametric Insurance Solutions with Higson

The demand for tailored and niche parametric insurance products will only continue to grow.

Designing parametric covers that meet both regulatory requirements and are attractive to buyers often involves multiple parties. This is why insurance carriers use business rules engines to deliver relevant products on the fly!

In the world of parametric insurance, business rules engines can offer a powerful solution for insurers seeking to streamline their risk management processes and deliver more accurate and efficient parametric policies to their customers.

Higson is a hyper-efficient business rules engine that can be configured in real-time with no code. Its user-friendly interface gives underwriters a bird’s-eye view of all the processes, enabling collaboration from team members across the company.

With little initial training, your insurance agent can create and manage parametric policies in Higson without any help from IT.

This user-friendly business rules engine shortens the development and deployment time of complex parametric insurance products down to minutes, allowing companies of all sizes to make better decisions and respond to market changes immediately.

Higson helps you represent the complexity of the world.

If you’d like to learn more about how insurance carriers can increase their market share with Higson, then schedule a free call with us today.

Get a personalized evaluation of Higson's potential for your use case
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