Parametric insurance: a game-changer or a threat to traditional insurance?

Insurer Update - December 2023

read timeRead time: 35 mins

In our era of climate change and the unexpected events it can cause, it makes sense that a different approach to insurance is gaining traction. 

As the world grapples with the intensifying effects of climate change, the insurance industry faces unprecedented challenges arising from physical, transition and litigation risks. 

Big and unexpected losses are nothing new in the insurance world. But they are also why the demand for insurance is unlikely to fade any time soon. The frequency of natural disasters is surging, and so is their severity, leaving a trail of destruction and financial hardship in their wake. And increasingly they’re happening in new locations that don’t have a history of such events.

Traditional indemnity insurance, the cornerstone of risk mitigation for centuries, is struggling to keep pace with these escalating threats. Parametric insurance is re-emerging as a serious alternative in a world where big data and artificial intelligence (AI) now have a more prominent role.

My first foray into parametric insurance was over 17 years ago as auditor and verification agent for an entity providing coverage for hurricanes and earthquakes. It was at a time when traditional players were either hesitant to underwrite the risks or price them at a very prohibitive level following some large losses in the region. This company later expanded into providing parametric rainfall coverage, and other programmes have replicated the base concept around the world.

The importance of advances in data 

Parametric insurance has presented itself as a transformative approach that promises to revolutionise risk management in the face of climate change. So far it has made limited progress into the traditional market. But are things about to change as a result of big data and AI?

Unlike traditional insurance, which reimburses the insured for actual losses, parametric insurance triggers pre-determined payouts based on objective parameters, such as wind speed, rainfall, or earthquake intensity. This innovative approach eliminates the need for lengthy and costly claims assessments. And that means accelerating the delivery of critical financial support to those in need.

Paradoxically, the future success of parametric insurance largely depends on how accurately and consistently it can model the actual losses that would arise from traditional insurance. Given the benefits of parametric insurance, if policyholders’ confidence grows in the parametric models to mimic actual losses, a paradigm shift is not just likely but might be for the greater good.

The benefits of parametric insurance

Parametric insurance offers a compelling list of benefits, particularly for covering hard-to-insure risks like natural catastrophes. Its advantages over traditional insurance include:

  • Rapid payouts. By eliminating the claims assessment process, parametric insurance speeds up the disbursement of funds, enabling affected communities to recover more quickly. Providing rapid relief after major loss events is a huge advantage when liquidity challenges could mean that businesses and governments fail. Even if traditional insurance could eventually pay out for the same losses, it might be too late.

  • Reduced moral hazard. The objective nature of parametric triggers lessens the risk of moral hazard, where insured parties take advantage of the insurance for their own benefit.

  • Dynamic pricing. Parametric insurance premiums are tailored to reflect the actual probability and severity of the insured event, providing fairer and more equitable pricing.

  • Data-driven insights. Parametric insurance uses advancements in data and AI to enhance product design, underwriting, and claims processing. This leads to more precise and effective risk management strategies.

What are the challenges?

Despite its transformative potential, parametric insurance faces challenges that need to be addressed before it is adopted more widely:

  • Basis risk. The potential mismatch between the parametric payout and the actual loss, known as basis risk, can leave insured parties exposed to financial gaps or windfalls. This is a critical success factor for parametric insurance. Advancements in data and AI are likely to reduce this risk over time, building more trust in these products.

  • Regulatory uncertainty. The regulatory landscape for parametric insurance is still evolving, creating uncertainty for both insurers and insureds.

  • Traditional insurance resistance. Traditional insurers may see parametric insurance as a threat to their market share, hindering its broader adoption.

  • Accounting and actuarial complexity. Parametric contracts will generally not meet the definition of ‘insurance’ contracts for accounting purposes and have to be marked to market as ‘derivative instruments’. This can add complexity to accounting and actuarial systems where finance and actuarial teams are not familiar with the accounting and modelling for derivatives.

  • Lack of understanding. This is, in my opinion, the biggest obstacle to large scale adoption of parametric products and it will take time for stakeholders to gain a better understanding of how this kind of insurance works.

Overcoming these challenges will need collaboration between insurers, regulators, and policymakers to set clear guidelines, improve transparency and foster trust in parametric insurance. Only by addressing these concerns will parametric insurance fully realise its potential as a game-changer in the insurance industry.

How might parametric insurance work in agriculture?

To illustrate how parametric insurance works, let’s look at an example of crop insurance. Suppose you are a farmer who grows avocados in a region that is prone to drought. You want to protect your income from the risk of crop failure due to lack of rainfall.

So you buy a parametric insurance policy that pays you a fixed amount of money for every millimetre of rainfall below a certain threshold during the growing season. The threshold is based on the historical average rainfall for your region, and the payout is based on the expected yield and price of your crop. The premium is calculated based on the probability and severity of the drought, derived from the historical and forecast data that consider different climate change scenarios.

The rainfall is measured by a network of weather stations that are verified by a third party. If the rainfall is below the threshold, you receive the payout automatically and quickly. If the rainfall is above the threshold, you do not receive any payout, but you still have a good harvest and hence are protected against adverse events.

This example shows how parametric insurance can provide a simple and effective solution for covering the risk of drought, which is one of the most common and devastating natural hazards for agriculture.

But it also shows how parametric insurance can entail some basis risk, as the payout may not match the actual loss. For instance, if the rainfall is below the threshold but your crop is still healthy, you will receive a windfall. If the rainfall is above the threshold but your crop is damaged by other factors, such as pests or diseases, you will suffer a gap.

So parametric insurance may not be suitable for all types of risk, or for all types of farmer. It may need to be combined with other forms of insurance, or other risk management strategies, to provide comprehensive and tailored protection.

From the insurer’s perspective, providing coverage across a broad range of geographies and risks will reduce its exposure to any single risk (such as drought in California). The principle of diversification for the insurer applies to both traditional and parametric insurance.

A paradigm shift in risk management?

I don’t believe parametric insurance is a mere substitute for traditional insurance. In my view, it’s a complementary or supplementary tool that adds to the risk management toolkit. It does this by boosting the resilience and sustainability of the insurance industry, and of society more broadly.

By harnessing the power of data, technology, and objective parameters, parametric insurance offers a more robust and responsive approach to risk mitigation in the face of climate change risk. As the world adapts to the escalating threats posed by climate change, it will play a pivotal role in safeguarding communities and economies against the devastating impacts of natural disasters.

Some insurers might perceive parametric insurance as a threat to their business model. But others see it as an opportunity to innovate and grow their market share. In a world full of uncertainties and possibilities, I believe that those who innovate and embed the technological advances into their business, whether traditional or parametric insurance, will prevail.

If you would like advice or further information on parametric insurance, please contact Satya Beekarry.