Parametric Insurance and Climate Change
Parametric insurance is a form of insurance that, whilst still relatively uncommon, is gaining greater prominence within the general insurance sector. Many people will be unfamiliar with the term, and even for those who may have come across it before there can be some confusion about what it is and how it works. In this article I explain how parametric insurance differs from traditional indemnity insurance and, by way of some example case studies, highlight how parametric insurance could become an increasingly important tool in dealing with the consequences of climate change.
What is parametric insurance?
Parametric insurance is an agreement to make a payment to the insured upon the occurrence of a triggering event, regardless of whether the insured has actually incurred a loss and regardless of the size of the actual loss incurred[i]. The insurance payout is triggered if the pre-defined event parameters are met, as measured by an objective parameter or index – hence the name parametric insurance, also known as index-based insurance.
The parameter will typically relate to weather (e.g. wind speed, rainfall, temperature) or seismic activity (e.g. earthquake magnitude), but human-related parameters can also be used – such as footfall through an airport or the values of stock market indices.
The key properties that make a parameter suitable for parametric insurance are that:
- It is objective: it should be reported by an independent third party
- It is reliable: it should be reported accurately and consistently
- It is timely: it should be reported quickly
- It is available/transparent: sufficient historical data should be available to enable modelling of the parameter
- It is correlated to the financial loss sustained by the insured
- It cannot be influenced by either the insured or the insurer
All of the natural (i.e. weather and seismic) parameters will also require a geographic area to be defined that determines the boundaries within which the chosen parameter is measured. Because the majority of parametric insurance has, to-date, focused on extreme weather events caused by natural catastrophes it is also sometimes referred to as ‘Cat in a Box’ insurance, as the payout is triggered when the Cat (hurricane or earthquake etc) occurs within the defined geographic box (although in practice this box will more commonly be a circle, centred on the insured’s property).
For example the insured may have paid a premium so that it receives a $10 million payout if a Category 5 hurricane occurs within the defined geographic area, but perhaps only a $5 million payout if a Category 4 hurricane occurs. National meteorological/geophysical agencies are commonly used to provide the measurements for these natural parameters – for example the National Oceanic and Atmospheric Administration (NOAA) for monitoring and classifying hurricanes in the US.
Parametric insurance versus traditional indemnity insurance
Under traditional indemnity insurance the insured pays a premium in return for the insurer promising to pay for any actual losses incurred caused by an event covered by the policy[ii]. The insurance is written under the principle of indemnity, whereby the purpose of the insurance is to put the insured back in the same financial position they were in prior to the loss event happening. This is fundamentally different to the way in which parametric insurance operates as, under parametric insurance, the payout is purely determined by the level of the parameter and not by the actual loss sustained.
The table below summarises the main differences between parametric and indemnity insurance:
Parametric insurance: advantages and disadvantages
As can be inferred from the above table, the main advantages of parametric insurance are:
- The faster speed of payout – particularly useful when responding to natural disasters, and for smaller businesses that have lower cash reserves
- Reduced costs of:
- Claims settlement
- Underwriting, particularly for more standardised products
- Renewals, due to multi-year agreements
- Greater certainty and clarity for the insured, who does not need to justify a claim amount or worry about policy wordings/exclusions and will know what claim amount they will receive
- Greater certainty for the insurer – as the claim payouts are pre-defined
- Due to the lower costs and reduced uncertainty, parametric insurance is/should be cheaper than traditional insurance – i.e. lower costs for the insurer and therefore lower premiums for the insured
- The simplicity of standardised parametric insurance products, which make them well suited to being marketed and sold via smartphones/apps. This, combined with the fast payouts, results in an appealing and streamlined ‘user experience’.
- Greater flexibility in how to structure the agreement – both in terms of the parameter used and the payout structure – meaning that a prospective policyholder can adjust the payout terms, and therefore premium, to suit their budget
- Moral hazard is largely eliminated, as are fraudulent claims
- Its application to, in theory, any risk for which a suitable parameter can be applied and measured – advances in big data and analytics will likely increase the types of risks for which parametric insurance can be usefully applied, particularly for more intangible risks that do not result in physical damage
The main disadvantages/challenges of parametric insurance are:
- It is only applicable where a suitable parameter exists
- There may be insufficient historical data on which to accurately constrain the probability of the trigger event(s) or – a key challenge for any type of insurance – the historical data may not be a good guide to the future
- The chosen parameter may not be a reliable indicator of the actual losses incurred
- The insured may retain considerable basis risk, particularly if the actual losses incurred turn out to be higher than expected when the contract was agreed
- It is less well understood than traditional insurance policies and, in general, the market for it is much less developed than for traditional insurance policies
- Potentially higher underwriting costs/complexity for very bespoke agreements
It is worth stating that parametric insurance is generally not designed to replace traditional indemnity insurance products. Instead, parametric insurance is typically used to either:
- Complement existing traditional insurance policies – parametric insurance may be used to speed up the payment of recoveries, or to fill the protection gaps and/or exclusions of the existing indemnity policy
- Provide insurance where there is a lack of capacity or appetite from traditional insurance markets, especially for risks that are underinsured or uninsured
Below I consider two case studies, one from each of the broad categories described above.
- Parametric insurance for a holiday resort in the US
Parametric insurance is well-suited to cover the more intangible, pure financial losses that impact businesses without necessarily causing physical damage to their assets. One such example would be to protect against ‘loss of attraction’ of a holiday resort due to a hurricane approaching whereby, even if the hurricane does not end up damaging the resort, the insured can be compensated for its lower business volumes over that period.
Here the parameter used could be the actual wind speed and hurricane category reached within a specified area or, under a slightly more protective/nuanced loss of attraction agreement, the parameter could instead be based off the number and/or nature of official hurricane warnings covering the area in question, so the payout would be triggered regardless of whether the pre-warned hurricane category actually then materialised or not. The company is protecting itself against people being put off from booking and attending its resort, with indemnity insurance still primarily relied upon for physical damage and traditional business interruption claims.
2. Parametric insurance for crop farmers in India
Farming in India is higher risk than in other countries because it has low irrigation coverage and hence crop yields are highly sensitive to both the amount and timing of local rainfall. Some Indian states offer state-subsidised traditional crop insurance but many of these schemes have failed to make claim payments in a timely manner and, as such, the majority of agricultural land in India remains uninsured[iii]. With a lack of effective traditional insurance and the farmers’ livelihoods highly dependent on the level of rainfall, parametric insurance is well-suited to help close this protection gap.
The parametric insurance can be structured so that the payout – typically an agreed sum per acre – is triggered if the amount of rainfall either exceeds a defined threshold (i.e. a flood) or falls below a defined threshold (i.e. a drought) over a certain period of time. The farmers are looking for protection against extreme experience, whether that be higher or lower than an acceptable middle range. Providing farmers with this layer of security in adverse years should enable them to invest (rather than save) the money earned in benign years to improve their farming practices and hence increase their crop yields and personal income. It is also valuable from the State’s perspective, as it reduces the risk that farmers become internally displaced or dependent on food aid.
However, this form of parametric insurance is not without its challenges. It relies on the availability of reasonably priced and reliable sensors to form a sufficiently dense array of rainfall measurements, backed up by regional monitoring stations to protect against these sensors losing connectivity or becoming unreliable (either naturally or through interference). Furthermore its usefulness will be limited in areas where groundwater/irrigation are the key factors in determining crop yields, rather than rainfall. Measuring groundwater availability is far more complex and groundwater levels are much more exposed to human (i.e. subjective) decisions regarding how/where to allocate water resources – e.g. through controls on dams and irrigation systems.
Parametric insurance and climate change
Weather events are well-suited to parametric insurance because the parameters involved (e.g. wind speed, rainfall) fulfil all of the key properties described in the earlier section – there is a strong link between extreme weather and financial losses, the parameters are relatively easy to measure, there is an abundance of historical data that can be used for modelling, the weather cannot be influenced etc. The key challenge for (parametric) insurance providers within the natural catastrophe space is ensuring that appropriate adjustments are made to models that are based on past data, as these may otherwise underestimate the frequency and/or severity of future extreme weather events.
Although (as discussed above) parametric insurance is by no means confined to natural catastrophes these remain its most common application and, due to the link between climate change and extreme weather, this seems likely to continue. A recent study[iv] expects the global market for parametric insurance to grow by 10% per year over the next decade to around $30 billion of annual premium, driven by the natural catastrophe sector, and there have been numerous start-ups that have raised significant venture capital in recent years[v].
One example of a natural catastrophe parametric insurance specialist is FloodFlash, which was founded in the UK and raised $15m earlier this year to fund its international expansion[vi]. The company offers parametric flood insurance that allows prospective policyholders to set a flood depth and payout amount when obtaining their quote. Using sensors, FloodFlash gets an immediate notification when the agreed-upon flood depth has been reached and the payout is then typically sent within 48 hours.
With premium rates hardening in traditional insurance markets, the industry having experienced some bad press over exclusions/policy wordings during the Covid-19 pandemic, more businesses now appreciating the need for effective insurance protection and extreme weather events continuing to intensify, the easy to understand nature, lower cost, flexible pricing structure and rapid payouts of parametric insurance look increasingly attractive – even more so to a generation of digital natives who are comfortable relying on modern technology to both execute the financial contract and monitor the trigger parameters themselves.
Parametric insurance providers targeting parts of the market that are currently uninsured are hoping that these advantages – especially the rapid payout, which is particularly important for smaller businesses – outweigh the downsides of imperfect indemnification. Ultimately, the lower cost of parametric insurance may even make it a direct competitor for indemnity insurance if these traditional products risk becoming unviable in areas that are particularly prone to extreme weather events. In a world where climate concerns remain front and centre, parametric insurance looks set to become an increasingly relevant tool to help mitigate against the effects of a warming and less predictable climate.
Parametric insurance is an alternative form of insurance that, rather than compensating the insured for actual losses incurred, instead provides a set payout based on the occurrence of a pre-defined trigger event, as measured by some objective parameter. Typically the chosen parameter relates to a feature of a natural catastrophe (hurricane category, rainfall, earthquake magnitude etc) but the insurance can, in theory, be based on any parameter that is objective, reliable and correlated with the actual losses sustained. In time parametric insurance may expand outside of its primary natural catastrophe domain as, with the continued evolution of big data analytics, more parameters can be monitored as suitable proxies for risks whose impacts are harder to quantify.
Parametric insurance is not designed to replace traditional indemnity insurance but to complement it – for example by speeding up payments to insureds – or to offer insurance in parts of the world where there is a lack of capacity and/or appetite from traditional insurance providers. Demand for parametric insurance looks likely to grow significantly in the future as the range and impacts of climate-related extreme weather events become more severe and unpredictable, and the product becomes more mainstream. As such, parametric insurance may become an increasingly viable option for helping businesses and individuals build climate resilience and strengthen their disaster recovery.
Sources and Further Reading:
[i] For the purposes of this article I am considering parametric insurance in its pure form whereby the contracts are effectively executed as derivatives and there is no requirement for a ‘proof of loss’. For further discussion on the differences between pure parametric covers (executed as derivatives) and hybrid parametric covers (executed as insurance contracts) refer to: https://corporatesolutions.swissre.com/insights/knowledge/10_myths_about_parametric_insurance.html
[ii] Some ‘traditional insurance’ policies provide fixed benefits whereby the payout is pre-determined for certain types of loss (eg a set sum assured for loss of limb or a set sum assured for a Fine Art policy), which makes them similar to parametric insurance to some extent – as pricing for these losses is determined purely by frequency rather than frequency and severity. However the vast majority of traditional insurance is written on an indemnity basis, and where policies do include a fixed benefit feature this is still typically wrapped up with indemnity insurance for other loss types. Therefore within the article the terms ‘traditional insurance’ and ‘indemnity insurance’ are used synonymously.