A new type of insurance policy is emerging in global markets: parametric insurance. As with any insurance coverage, it comes with both benefits and risks. To determine when it would be appropriate to take out a parametric cover, we must first understand its function, appreciate how it sits with existing policy cover and be aware of its limitations.

At a bare bones level, it works like this: something specific happens (a pre-identified trigger), and the policyholder is paid a pre-determined amount of money automatically. Instead of indemnifying for an actual physical loss, parametric addresses the probability of an event happening. It’s a specific solution to a specific problem.

Key features and functions of a parametric cover

First, the pre-determined trigger should meet a number of standards:

• Clearly insurable: policyholder must have insurable interest ie a stake in the future health of an asset/income stream (otherwise it would just be gambling)
• Can be independently measured by third-party analysis (so the availability of historical/statistical records or data to allow for modeling and pre-estimation is a must)
• Objective and factual
• Outside of the policyholder’s control (e.g., a weather event)

Then, using a third-party analysis of relevant data, the policyholder and insurer must agree upon a monetary amount that’s estimated to cover that specific loss. Once the trigger has occurred, the pre-agreed payment amount is automatically paid into a bank account specified pre-loss, within an agreed-upon timeline. All information is exchanged pre-contract between the insurer and policyholder.

These covers function in one of two ways, based on policyholder preference: either to insure the premises for a potential future loss of profit, or to cover costs if a potential situation were to occur. The latter is an easier call to make; the cost of the tangible premises a policyholder looking to cover is clearer than coming up with a monetary amount of profit a policyholder is likely to lose. If you’re hiring a boat with a large crane on it, you know in advance what the cost of that is — the cost of the boat and crane. So, if you’re taking out a parametric cover on the basis that severe weather may damage the equipment, you’re already aware of the number you’re looking to cover. It’s a lot more difficult to estimate a loss of profit amount.

It's important to note that a parametric cover should not replace an all perils or all risks-based business interruption policy — parametric is complementary to, but not a replacement for, the main cover.

Example scenarios

Parametric policies involving catastrophe and weather events, especially floods, are among the most common. A farmer might take out a parametric cover for flooding that could cause crop failure. First, a clear, insurable trigger is identified (in this case, a minimum amount of rainfall or flood water, pre-determined and agreed upon between the policyholder and the insurer, that would cause damage to the premise). Sensors would be attached to the premises to monitor water levels and, if enough rainfall accumulates to exceed that water level, the sensors instantly send the data to initiate the claim. The farmer receives an automatic, pre-agreed payment amount into his chosen bank account.

In Japan, parametric is already appearing in the context of personal lines and commercial coverage involving earthquakes. The insurable trigger would be a specific earthquake intensity; if an earthquake exceeds the agreed-upon intensity level on the Richter scale, the pre-agreed payment would be paid out instantly.

There are also several quick solutions to flight delays and cancellations using parametric solutions, with pre-agreed delay periods currently ranging from three hours to cancellation. If the flight is delayed for three hours, for example, the policyholder might have the option to receive a pre-agreed amount in their bank account; for six hours, it might be a higher pre-agreed amount or an overnight hotel stay.

The risks

One inherent risk of parametric cover is that the policyholder bears the burden of estimating the loss. If the initial risk analysis was incorrect, the settlement amount may be significantly less than the loss that’s occurred. And for policyholders, there are no assurances of accurate pre-estimation, no formula or calculation to ensure reliability. In other words, the payment may not cover the loss incurred, and expectations may not be met. Some smaller companies may not be able to fund the necessary risk assessments or have enough data to be analyzed.

Remember, a parametric cover is a specific solution to a specific problem, not a cure all. A parametric flood cover is of no use if the building burns to the ground, after all.

Parametric: the answer to what?

With traditional policies, such as damage at the premises, it’s easy to assume that everything is covered. But there must be a limit to the scope (limitless scope would mean limitless premiums). That’s where parametric is helpful — to fill in the gaps. If done correctly, there’s a minimum burden of investigation, because all work will have been completed pre-loss. And it requires only that the threshold for the agreed upon risk is met.

This objective approach also means claims are paid expediently, and automatically. Parametric covers could be a useful addition for owners, contractors or developers exposed to significant weather events, or the average person who travels frequently and wants to prepare for travel delay risks.

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