What is it?
Parametric insurance is a term that we haven’t heard of right? Well, despite being uncommon, compared to the pre-existing insurance schemes it can fill in the gaps left by traditional instruments. So what exactly is Parametric Insurance? It is a type of contract between the client and the issuing party where there is a payout that is based on the occurrence of a specific event and its magnitude. This is opposed to the current insurance policy where actual damage is needed for you to get your money. It resembles a disaster security scheme, where if there was to be a 5.0 magnitude earthquake, then one would get ₹1 crore as insurance. However, if the magnitude is greater than 5.0, then one would be paid ₹5 crores.
This scheme consists of two parts - a triggering event and a payout mechanism. Insurance is triggered when a predefined event takes place and causes damage to your asset. This event is the “triggering event” and the money received regardless of any actual damage or physical loss is the payout mechanism. The conditions i.e the parameters are that the payable amount and a third party, usually a government agency which is responsible for assessing the parameter (the one against which you get a payout), have to be mentioned in the contract signed.
What do you mean by a parameter? Well, it is an objective measure that is co-related to a specific risk that can cause a financial loss, for instance, an earthquake destroying a property. These “parameters” are usually easily measurable for example a cyclone, earthquake, etc and it should also be such that they can’t be influenced by a client or the insurer. This is why usually these risks are “acts of god” i.e environmental hazards.
The advantage parametric insurance has over your regular insurance schemes is:
There is an already pre-agreed payout scheme that is evaluated based on an event parameter as compared to your normal scheme wherein there is reimbursement based on the level of damage caused. In parametric insurance, even in the event of no physical damage, one still receives a payout.
The Claim Mechanism is easy, open, and quick (can be done in 4 weeks). The only thing that needs to be assessed is the measure of calamity.
As a scheme, it is pretty flexible and its risk can be tackled by formulating a really strong contract structure, using double trigger events, and a good payout policy as well.
Well as it is said nothing can be all flowers. Parametric insurance also has its own set of challenges and risks involved.
Firstly since a lot of people aren’t even aware of such a policy, they miss out on the advantages offered by it. Secondly, one needs to be very thorough with the contract. The client should understand what he/she is signing up for and be extremely aware of how he/she is planning his/her payout, how effective it is in case of an emergency, and make sure there are no flaws in it. The client should also make sure of using double triggering parameters. For all this to happen, the client needs to understand what exactly threatens their asset and which parameter suits them.
Also one needs to analyze what can be the economic impact if the situation changes (basis risk) and this is not due to the parameter being triggered. Yes! This is also very much possible, for example, during the Malawi drought in 2015-16 when the government had initially bought parametric agricultural scheme insurance from African Risk Capacity. Before the season of the drought, the farmers shifted to a new crop with a shorter developing cycle and this is more prone and can be affected and exposed to drought conditions. In this case, initially, a payout wasn’t triggered as it was not predicted that the losses would be so widespread. To tackle this again you should be very aware of your contract and also be smart and have higher premiums and a well-structured scheme.
Although Parametric Insurance has been around since 1997, it has grown in popularity in the last five years. The increasing environmental concerns and the frequency of natural disasters are the primary drivers of this expansion.
In the last year alone, we've witnessed earthquakes, cyclones, and floods wreak havoc most of which unfortunately aren’t covered by insurance. Natural disaster losses in Asia totaled $31 billion in 2017, yet only $5 billion of it was covered by insurance. The growing frequency of such climate disasters, as well as the greater efficiency of parametric solutions in dealing with such events, have contributed to its popularity.
The amount of data that is now easily available is another reason why parametric insurance has grown more feasible. The technology available at the time of its conception, in 1997, was still limited. It was difficult to quantify the actual scale of certain events, such as typhoon wind speeds or rainfall amounts. It is now easier to model new parameters for various disasters and determine the actual magnitude of an event, thanks to the data available and the fact that most parts of the globe can be monitored 24 hours a day, seven days a week.
Finally, this scheme significantly reduces the problem of insurance fraud. Because the casualties are verified by third parties, the majority of which are government agencies, cheating the system is exceedingly rare. Moral hazards are also avoided with parametric insurance. A moral hazard occurs when someone takes extra risk in the belief that they will be protected against it, such as a truck driver who drives recklessly after getting his vehicle insured. However, the payout is based on established parameters that are not subjected to human influence under parametric insurance, removing this problem.
Considering the benefits of Parametric Insurance and the advantages it has as compared to a traditional insurance policy, it does have a bright future.
Firstly, parametric insurance can greatly help in protecting vulnerable communities. For a person whose life has been turned upside down by a calamity, time is of the essence. In traditional insurance, the person affected has to go through a grueling and tiresome process to get their claim. The process starts with an insurance agent evaluating how much loss the aggrieved party has suffered which wastes a lot of time. In Parametric insurance though, as the process simply involves confirming from a third-party agency the magnitude of the event, payment can be released in a shorter time, and this saved time is invaluable.
Parametric insurance in the future can also help in taking into account those risks which regular insurance fails to account for. There are scenarios where there is no physical damage, however, there are interruptions in business that increase costs and lower revenues. For example, if the water level in a river drops beyond a certain point, while ships may not be damaged, for a small shipping company, it can mean increased time of shipping and thus loss of revenue. While a regular insurance policy may not account for this, parametric insurance can be taken, wherein a payout is triggered if the water level drops beyond a point. This helps to compensate for the loss in revenues.
In 2017, Hong Kong’s Swiss Re Corporate Solutions won the award for the most innovative product/service. Can you guess what the service was related to? It was of course Parametric Insurance. The issue at hand was that Typhoon Haima was approaching Hong Kong which kept people from visiting their businesses and led to a loss in revenue. Thus the exact loss was calculated if the typhoon was over the warning single 8, which was HK$ 4.29 billion per day.
Authors: Soumil De and Tushasp Rajput Illustration by: Sai Aditya M