‘Parametric’ coverage pays based on magnitude of events rather than value of loss
The increasing frequency and intensity of natural catastrophes associated with climate change has roiled the insurance industry, executives say.
Testifying before the Senate Budget Committee earlier this year, Eric Anderson, president of risk mitigation consulting firm Aon, said, “Climate change is destabilizing the insurance industry.”
The National Oceanic and Atmospheric Administration reported that in 2022 alone, the United States was struck by 18 weather events traced to climate change, including hurricanes, floods, tornadoes and wildfires, with losses of at least $1 billion, which amounted to losses of $175.2 billion. During the decade from 2000 to 2009, the annual average of events with losses of $1 billion or more was 6.7, while annual average losses were $60 billion.
Since January 2022, property insurance premiums have risen by double digits in 31 states, and by between 20% and 30% in six of them, notes Alice Hill of the Council on Foreign Relations. Insurers have declined to renew existing policies or write new ones in states most prone to catastrophic events, notably Florida and California.
Traditional property insurance primarily applies to material damage and indemnifies the insured for the actual value of the loss incurred. The insured assesses the damage and submits a claim, which is reviewed by the insurer then adjusted and validated before ultimately being paid. The process is lengthy, costly and frequently contentious to both insurers and insureds, especially when the damage, like that from natural catastrophes, is severe and widespread.
“The traditional insurance market is especially difficult to navigate,” Anderson writes.
“Risk managers and business leaders must be prepared to make better decisions when faced with natural catastrophes, starting with the use of parametric insurance.”
Protection against severe weather events
Parametric insurance pays a predetermined amount based on the measured magnitude of the event as opposed to the assessed value of the loss. These policies cover not only material damage but also can be written to include financial impacts such as lost earnings from interrupted business operations, foregone income to displaced employees, and outstanding payments to suppliers and service providers. Above all, payouts are immediate, restoring liquidity and ensuring cash flow.
For example, the characteristics of a storm — the volume of rainfall, force of wind, level of flooding, rise of sea level, size of hailstones — are measured by objective, verifiable third parties, particularly government agencies like NOAA and the National Weather Service, immediately after the event. The data serves as the parameters or triggers of the insurance contract. When the parameters are matched or exceeded, payments are issued promptly.
Parametric insurance has grown since the 1990s when several Asian countries began protecting their agricultural sectors against severe weather events.
A decade later Swiss Re introduced typhoon warning insurance for companies in Hong Kong, and French firm AXA began offering insurance against climate risks. By 2020 parametric products providing protection against risks from infectious diseases to natural catastrophes were staples of large insurance companies.
In 2021 the global market for parametric insurance was $11.7 billion and projected to reach $29.3 billion by 2031.
Data-driven insurance model
Parametric insurance streamlines the tasks of underwriting policies and processing claims, efficiencies that both reduce the overhead expenses of insurers and ensure timely payouts to insureds. Since claims are triggered by objective, verifiable data, the likelihood of disputes is significantly less than that with traditional insurance policies.
The major downside of parametric insurance is “basis risk,” the possibility that the contractual payout amount is less than the actual loss incurred. With a traditional policy, the basis risk is the deductible and with it the risk that the losses will either be excluded altogether or exceed the limits of the policy. With parametric policies, the basis risk is greater, because the actual losses may fail to trigger the policy altogether.
While parametric policies are most common in the property catastrophe market, they can be written to cover any sort of event that can be objectively measured and causes a loss. For a construction company, a policy could be triggered by the number of working days lost to foul weather, while for a retailer a policy could be triggered by the decline in sales arising from a pandemic.
Since parametric insurance is data driven, as technology expands capacity to collect and manage data, its applications for quantifying and managing risk expand with it.
Policies can be tailored to the particular risk profiles and tolerances of particular insureds, lending a bespoke quality to each contract.
Andrew Demers, spokesman for the New Hampshire Insurance Department, said the department has not approved any parametric insurance products.
