Parametric Insurance - What Is It?

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At its most basic, insurance is a transactional exercise based on probability. Insurers collect immense amounts of data to calculate the likelihood of an event (peril) occurring. This risk is then spread across a large pool of insureds who pay a financial fee (premium) to the insurer to bear the risk and reimburse the insured should a loss actually occur. At the heart of determining the risk is data – gathering information, examining historical records of similar events, crunching the numbers.

But what if there is no data, or at best very little information on which to determine insurability? If the event occurs infrequently and there is insufficient history of losses captured as insurance-readable data, what can you do? And if the event has secondary consequences, such as in a natural disaster, how do you protect yourself against a potential cascade of unintended losses?

Enter parametric insurance.

Say you operate a business in the desert of California, which this week was hit with two sizable earthquakes. There probably wasn’t enough information to make an informed assessment of the likelihood of the earthquakes occurring under conventional actuarial methods and what those losses might look like. But parametric insurance removes the guesswork by promising to make a payment upon the occurrence of a triggering event rather than indemnifying the pure loss.

As a result, the concept of a cedent (the insured) is not exactly accurate when delving into the world of parametric insurance. Instead, the insured is often referred to as the “protection buyer,” the party who purchases a pre-defined amount of protection that will pay-out based on pre-defined terms. The pre-defined terms are the parameters, hence “parametric” coverage.

What the parameters constitute is obviously essential. They serve as the trigger mechanism to the pay-out. The parameters are typically defined as the risk the buyer seeks to obtain protection against. It could be hurricane wind speed, rainfall, tornadoes or as in the recent case of Ridgecrest, CA, earthquakes.

The advantages of parametric insurance include the ability to make rapid pay-outs without the time lag of loss assessment. If the trigger parameter is reached the pay-out is issued. Done. The other major benefit is the predictability of the pay-out - there is no contested claims as the definition of what constitutes the loss falls within an agreed and well-defined parameter.

What is critical in designing the trigger mechanism is to understand the conditions to be used and how they relate to a potential financial or economic loss to the protected buyer. Once defined, any parameter can provide a highly accurate and reliable protection should those conditions occur. There are no claims-delaying payment processes and disputes are minimized. In fact, no loss adjusters are required. The only caveat is to make certain the reporting station or agency providing the parameters on which the pay-out is triggered is reliable, trusted and independent of either party to the contract.

The world may appear to be less predictable, shakier and interconnected, a condition replete with opportunities for insurers to offer the advantages of parametric coverage. Consider, for example, the increasingly perilous state of our weather and natural disasters, which annually seems to set new records for extremes. It would appear parametric insurance will increasingly become popular as a means to facilitate better assured protection to buyers of this all-too-often recurring phenomena.

A variant on the concept is Transinsurance. It focuses on non-catastrophic events that have secondary effects not covered under conventional property and casualty policies. Complex coverage definitions and loss adjustment processes are eliminated by defining the coverage provided as a percentage of the loss recoveries under traditional liability policies. In this way what was previously uninsurable is now insured, allowing the insured to deal with the full impact of the loss event.

The end result of these innovations is definable, equitable and facilitated loss recovery by insureds for losses that were previously untouchable. Surely there is a win in there for everyone. It makes you wonder how many folks in Ridgecrest knew about this...


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