Using parametric insurance to mitigate our changing planet

Climate change is causing an unprecedented increase in freak weather patterns – and in return, insurers are turning to parametric insurance as a solution

Parametric insurance is a type of insurance cover that provides a pre-agreed payout to customers in the event that predefined parameters are met. In recent years, it has proven particularly popular for insuring businesses and homeowners against the risk of natural catastrophes (nat cats); when water levels, wind strengths or seismic activities reach a certain level, the insurer pays out an agreed sum to the insured party.

As it negates the need for loss adjusters, parametric insurance is able to provide much quicker compensation to customers after the fact. The automated nature of parametrics pulls data from public sources, like weather agencies, meaning a quicker and more seamless claims process. So is it all it stacks up to be?

Where is parametric insurance most popular?

Understandably, parametric insurance has been heavily weighted so far towards nat cats, for which it is particularly suitable. The data is readily available; insurers understand the impact that serious nat cat events can have; and there is a need to deal better with the significant damage caused by hurricanes, wildfires and earthquakes – something that will only get more problematic in the coming years, as climate change continues to affect our planet.

“We view parametric products as a way to augment the market and provide coverage where other insurers are unable,” says Mark Hara, US CEO of FloodFlash. “The protection gap we are hoping to fill is often caused by a combination of difficulties modelling the damage caused by flooding or securing capacity. You can see these factors play out across the US, perhaps most predictably in Florida. On the other side of the country, California may not have the same risk factors – but underinsurance is still a huge problem. That’s to say that severe weather risk isn’t isolated to one particular area. All 50 states have experienced floods in the last 10 years so there’s a large market out there for new products to help.”

Parametric insurance has provided proof-of-concept in the US, which faces a multitude of severe weather events from coast to coast every year. But it’s also beginning to gain traction in other parts of the globe that face extreme weather.

Peter Lacovara, Head of Commercial at Floodbase, explains: “Growth in parametrics largely began in the most natural catastrophe-prone regions, where capacity constraints and the physical damage focus of indemnity left significant economic value exposed. Over time, however, parametrics have demonstrated unique value in lower-data environments such as the developing world, where the requirements of traditional underwriting can be harder to meet than those of parametrics.

“From a committed capacity standpoint, the vast majority of parametrics are still nat cat covers,” he continues, “but the value of parametrics in low-data environments is fueling swift growth in non-cat exposures where indemnity is less competitive, or can’t be delivered at all.”

Achieving scale with parametric insurance

One obstacle holding parametrics back is its ability to scale. This is primarily driven by the cost, FloodFlash’s Mark Hara claims. “Modelling is certainly one part of that – but you also need to collect accurate, reliable trigger data in a cost-effective manner. FloodFlash emerged from advances in affordable IoT technology and data processing. We’ve mapped every single property in the US and can provide a quote after just a few questions now. The parametric boom we are seeing now is a reaction to protection gaps around the world, but it wouldn’t be possible without the tech and data innovation that underpins each product.”

Despite these cost challenges, it isn’t always necessary to gather separate data for every catastrophe you insure or every market you enter. Peter Lacovara elaborates: “For many perils such as floods, parametrics require considerably less ‘local’ information and modelling, and can be extrapolated more easily than traditional indemnity.  

“Moreover, knowing every detail of the underlying risk isn’t necessary; for example, ample parametric capacity has been deployed in the US Pacific Northwest, even though we have rarely witnessed the M9+ events we know the Cascadia region can produce. More recently, programmes have been developed for countries in Latin America and Africa where there is, in some cases, as few as 20 years of data.”

Conveniently for parametric insurers, the scope for each policy is much narrower than traditional homeowners’ insurance, so risk becomes slightly easier to manage. Lacovara continues: “The core pricing mechanism for parametric insurance is typically only reliant on a single degree of freedom – how likely is a specific set of events to happen? Thus, carriers must only price for the uncertainty of that single set of events. Relative to indemnity insurance (which has many elements of uncertainty), this gives more margin for error for that one estimate, and makes parametrics inherently more scalable and means they require less data overall.”

What future risks will parametrics underwrite?

Both our experts are excited by the opportunities that increased uptake of parametric insurance would provide. Although most emerging risks are not currently covered by parametrics, some might be in the future.

“Just a few years ago, even parametric flood wasn’t possible at scale,” explains Floodbase’s Peter Lacovara. “However, the commercial satellite industry has provided the information necessary to build these parametric programmes worldwide. Similarly, wildfire has emerged as a parametric solution that relies on satellite data unavailable a few years ago. 

“It’s unlikely that the parametric insurance industry will directly drive much of the innovation that’s necessary to insure new things on a parametric basis – but more likely that carriers, MGAs, brokers and insurtechs will find new and clever ways to use technology to do so.  There’s an adage: ‘If there’s data, you can build a parametric’. While not literally true, the spirit is probably correct.”

“It’s a well-worn phrase but it’s true to say that if you can measure something, you can create a corresponding parametric insurance product,” says Mark Hara. “We’ve seen great examples of parametric insurance in varied use cases from freight insurance to server downtime coverage.”

Hara believes that, eventually, we will see parametric insurance unshackle itself from the bounds of nat cat lines: “We envision a future where, with the right data, you could feasibly insure against drops in customer sentiment or other non-damage impacts on business profitability,” he says. “There’s a lot of growth yet to emerge from the parametric markets.”

Working hand-in-hand with indemnity insurance

One of the industry’s sore points so far – at least in the eyes of the consumer, who is only interested in affordable cover that pays out when their property is damaged – is the notion of parametric insurance as a stopgap measure. The lack of loss adjusters means quicker claims payouts. Still, it can also lead to customers being out of pocket if the actual loss they incur from a serious weather event is greater than the compensation agreed with their insurer when they took out the policy. Consequently, many consumers see parametric insurance as a type of ‘bounceback cover’, used to get them back on their feet while they wait for their traditional insurance policy to run its long and arduous course.

This is a perception that parametric insurers must address – but collaborating with incumbent insurers could be the sector’s strength, rather than its weakness. “Negative basis risk – the difference between actual economic loss and insured loss – is a potential challenge to parametrics,” Lacovara says.  

“Indemnity, however, also has basis risk: it’s included as terms, conditions, deductibles, exclusions, sub-limits and so on. The brightest future for indemnity and parametric is incorporating the best elements of each into a more cohesive solution, which provides the expediency and broadness of a parametric while eliminating gaps.

“While many parametric programmes are designed to dovetail with conventional indemnity programmes, they continue to be separate policies largely because of the challenges of aligning two necessarily different policy forms. Many insurers are looking at offering indemnity and parametric together, especially in the personal lines space. For flood or wind coverage, individuals can benefit immensely from the addition of a parametric as an endorsement onto a homeowner’s policy. A single buying process with aligned policy forms would increase parametrics’ penetration into all insurance segments, and close the global protection gap.”

“There are many more ways in which [parametric policies] can work to benefit customers and insurers – particularly in the reinsurance space,” Hara adds. “That’s why we’re always keen to show how parametrics enhance the market as an additional source of coverage, rather than competing for the same policies.”

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