Parametric Insurance: What You Should Know

Parametric insurance provides coverage that is triggered solely by the occurrence of a narrowly defined (“parametrized”) event, mostly eschewing the lengthy process of determining the loss amount and instead pre-defining a dollar payout based on the magnitude of an event and not a claim adjustment process. The NAIC defines parametric insurance as, “a type of insurance contract that insures a policyholder against the occurrence of a specific event by paying a set amount based on the magnitude of the event, as opposed to the magnitude of the losses in a traditional indemnity policy.”

Dating back to the mid-1990s, some of the first instances of parametric insurance emerged as developing nations in Asia sought to design index-based insurance to counter the risk of severe weather on agricultural communities. Parametric insurance continues to grow in areas prone to climate risk due to its flexible and efficient coverage.

As the name implies, parametric insurance pays out a set dollar amount automatically when an event with pre-defined parameters occurs, which may not align with actual damages sustained by the insured. Typically, these pre-defined parameters are narrowly designed so that it is very likely that the insured does in fact sustain damages from the event. A parametric version of automobile collision coverage might trigger coverage if a deceleration from 60 MPH to 0 is detected in a period of under 1.5 seconds – while this event does not guarantee that the insured sustained damage, it is very likely that they did.

Because of the nature of how coverage is triggered, there are some unique aspects to this type of coverage. Here’s what you should know before diving into parametric insurance product development.

Third-party verification required

The NAIC continues, “The amount of payment, the parameter, and a third party responsible for verifying that the parameter was triggered must all be specified in the contract. The third-party will usually be a government agency; for example, earthquake magnitude could be determined by the measurement issued by the National Earthquake Information Center. There will often be a tier of third-party verifiers as a contingency plan in case the primary agency is incapacitated.” In the automobile example above, there may be a vendor that provides a device for real-time vehicle diagnostics in order to verify the deceleration metrics.

Benefits of parametric insurance

Parametric insurance delivers fast, transparent, and customized coverage tailored to the specific needs of insureds, offering support and peace of mind when it matters most. Here are some of the main benefits of this type of coverage.

Instant payout

Parametric insurance pays out a defined amount within days of a triggering event, eliminating the time drain and complexity of assessing actual damages associated with traditional claim processing. The speed of claim verification and defined payout dramatically streamline the claim process, resulting in an improved experience for customers.

Reduced overhead expense

The simplicity of claim verification and payouts dramatically streamline the claim process, resulting in lower claim adjusting expenses and thus, competitive pricing.

Time-critical response

Insureds have access to payout funds almost immediately, providing relief during the period right after a triggering event, which is especially helpful in the case of natural disasters when aid in the immediate aftermath is crucial. The speed of payouts dramatically streamlines the process of filing a claim, resulting in an improved experience for customers.

Fills unique coverage gaps

Parametric insurance policies can be designed to fill coverage gaps in cases where loss adjustment would ordinarily be difficult or impossible. Since coverage is triggered by event magnitude rather than loss magnitude, coverage can be afforded to perils where that loss magnitude can be difficult to calculate.

Tailored to specific risks

Parametric insurance product development is often the result of professionals in a specific field who have first-hand knowledge of risks in their respective industries that fall outside of the scope of traditional insurance coverage.

Basis risk challenges

Basis risk in parametric insurance refers to the discrepancy that may occur between the payout triggered by the parametric coverage and the actual loss experienced by the policyholder. Depending on how the triggering event is defined and on the payout selected, the claim payout could be higher or lower than actual damages sustained since no claim adjustment exists. The payout selected should align with expected damages, which often includes expense items such as unexpected travel costs, deductibles, and debris removal. To minimize basis risk, the parametric product can be designed to use sliding scale payouts or other innovative product features to ensure effective risk transfer while supporting reasonable company profitability. On the other hand, if there is a chance that the policy overcompensates the insured, the underwriter can be exposed to a significant moral hazard. This is why it is imperative to carefully define the triggering event.

Limited historical data requires careful analysis

One of the benefits of designing a new parametric product is that a company may be first-to-market. However, the absence of a direct competitor also means a lack of available competitor pricing data. Pricing for parametric insurance is often done from first principles.

When designing specific triggers, accurate interpretation of historical data is critical. Working with experienced actuaries is essential to ensure that their interpretations of the data result in accurate risk assessment and pricing. The actuarial consulting team at Perr&Knight has deep experience developing pricing from raw data and our rigorous peer-review process further bolsters confidence in the interpretation of available data.

Parametric insurance product development checklist

Insurance innovators looking to develop a parametric product should keep these considerations in mind.

Is parametric coverage beneficial?

Many scenarios that seem like they might suggest the development of a new parametric insurance product are covered by existing policies or might actually not be an insurable risk at all. For parametric products in particular it is also necessary to ensure that the insured has an insurable interest related to the event being triggered. Since coverage is triggered based only on the occurrence of an event, the insured must plausibly sustain damages from the occurrence of the event. Consulting with insurance product development experts during initial ideation is essential to avoid investing too heavily in a policy that may be redundant or might not even fall within the scope of insurance.

Obtain accurate data

Coming to the table with a set of high-quality data speeds along the process of accurate rate development and reliable parametric triggers. Policies designed around easily obtainable and verifiable data require less time to develop pricing. Better access to real-time data from satellites, weather stations, etc., has allowed insurers to create more accurate and reliable parametric triggers in the catastrophe space.

Be aware of jurisdictional nuances

Understanding what is required by state departments of insurance (DOIs) is a challenge for all types of insurance product development, but it’s especially tricky for parametric policies. Though all 50 U.S. states and the District of Columbia have examples of approved parametric policies, many state DOIs are still very skeptical of the benefits to consumers. This is where partnering with experienced insurance consultants like the team at Perr&Knight can be hugely beneficial. Our filing experts understand the small but important variations in requirements in jurisdictional requirements and they have the expertise to guide you to the most practical regulatory implementation of your product idea, whether it be the admitted market or surplus lines.

Parametric insurance policies offer ways to better serve customers by protecting them against hard-to-place risks, filing gaps in their existing coverages, and paying out quickly. However, hasty product development can lead to trouble down the line with regulatory requirements, or pricing inaccuracies that could lead to financial or reputational risk.

Partnering with insurance product development experts early on and leaning on their experience throughout the design and filing processes can help insurance companies and entrepreneurs sidestep avoidable errors and focus on bringing a quality product to market faster.

Contact the experts at Perr&Knight today to discuss your parametric insurance product.