Parametric Insurance Article

Before we discuss parametric insurance, let's define it, explain how it works, and provide a concrete example.

Parametric insurance is structured around a pre-agreed index or parameter. Once that threshold is reached, a predetermined payout is triggered. This payout can be issued in stages as different thresholds are met or in full when a specific condition is satisfied.

Many types of parametric policies exist, but the most common—and widely purchased—are designed for natural catastrophe risks, such as windstorm or earthquake exposures.

For example, consider a hurricane in Florida. If you purchase a parametric policy that begins paying out when a hurricane reaches Category 2 strength, the policy would be triggered once wind speeds hit 96 mph. The payout structure might look like this:

• 25% payout at Category 2 (starting at 96 mph)
• 50% payout at Category 3 (starting at 111 mph)
• 75% payout at Category 4 (starting at 130 mph)
• 100% payout at Category 5 (starting at 157 mph)

This structure allows for faster, more predictable claims processing and provides financial certainty when specific event thresholds are met.

Why are companies more and more interested in buying this type of insurance?

There are many reasons, and each client might have a different primary reason, but companies generally buy this to supplement their regular indemnity-based property insurance policy. While we have seen clients replacing their traditional insurance property policy with a parametric Natural Catastrophe policy, it is usually a deductible fill-in for their property program.

One advantage of a parametric policy is that, in most cases, it does not have a deductible. For example, indemnity-based NatCat policies for critical locations such as Florida have a windstorm deductible of 2 to 10% of the insured's value. On the other hand, clients buy a parametric policy based on the limit they believe they need. The rate is based on the limit they purchase and not on the property's insured value.

A traditional indemnity-based property insurance policy is based on the client's total insured value and exposure profile, and the underwriting of the risk can take much longer than buying a parametric coverage. For parametric coverage, you usually only need the longitude and latitude coordinates of the desired (tangible and intangible!) asset that will be insured.

Another reason clients look at parametric coverages is that the claims payout is much faster than a traditional insurance policy. On average, it takes 15-30 days for a claim to be paid and is without a complicated claim adjustment process.

In addition, there are instances where the traditional market is unwilling to insure a specific asset at a certain location, or the deductible for that particular asset is too high. Therefore, a client will look to purchase a parametric policy instead.  

What are some of the pros and cons of this type of structure?

We touched on some of the pros of parametric policies: No deductible, much faster claims payout, and very little information needed to buy such a policy. Other advantages & disadvantages can include:

• There aren't any exclusions like there are in a traditional insurance policy, so there is more policy certainty. The policy pays out based on predetermined thresholds.
• A loss can be interpreted much broader than what a traditional policy defines as a loss, including nonphysical damage, business interruption, or other economic losses.
• Parametric policies are usually deductible fill-ins based on specific perils, vs. an all-risk policy that covers you from many different perils.
• Parametric policies tend to work well for strategic locations or areas.

Some multinational clients have such a comprehensive geographic footprint that a parametric policy is difficult to place and becomes cost-prohibitive.

We hear a lot about "basis risk" on parametric. Could you explain the basis risk for parametric? Are there ways to lower that basis risk?

Basic risk is the risk that the policy will not respond as intended. It pays based on data provided by a 3rd party and not your actual loss (as they are not perfectly correlated). An example might be best to explain this:

Let's say you have a beautiful hotel on the water in a hurricane-prone area and buy a traditional property policy with a windstorm deductible of 5% of your $100M total insured values. So you decide to buy a parametric policy with a limit of $5M (for that deductible) for your FL location that you are concerned about.

In the beginning example, that parametric policy starts paying out at Cat 2 (so at 96mph) with a 25% payout, 50% at Cat 3, and so on.

For these parametric products, you always have an independent third-party agency that reports the windspeed (NOAA – National Oceanic and Atmospheric Admin in this example).

You pay your policy, a hurricane comes, you incur some losses, and NOAA determines that the windspeed was 95mph based on their data. You are extremely disappointed because everyone, including all the TV stations, talked about how crazy high the windspeeds were, way in excess of the 95mph that the third-party agency reported. That is one example of a basis risk. 

With more customized parametric policies, there are many ways to reduce basis risk, and that's one reason why you should come to us with your parametric needs!

What is a typical underwiring process and timeline, and what information must a client provide for a quote?

It depends on the complexity of the risk. For a single location and a basic need, it can take 24 hours. Depending on how customized the solution is, it can take a few days or longer for more complex and large accounts.