Parametric Insurance: A Sure Bet on Nature’s Gambles

Parametric insurance sounds a lot like betting on horses. In betting on horse races, there is a set threshold – the finish line – that must be crossed to trigger a payout. In parametric insurance, there is a threshold that set parameters must cross to trigger payout. In both these instances, once the threshold is crossed, the payout is triggered automatically. A parametric policy is purchased, much like a bet is cast, and the insured waits for their “horse to come in,” or the predetermined natural event to meet threshold criteria. How does parametric insurance work? Let’s dig in.

Policy Coverage

Parametric insurance is policy coverage triggered by agreed upon parameters coming together and crossing a predetermined threshold. It differs from standard insurance in that damages and valuation are not part of the parametric equation. Generally, this type of coverage is centered around a natural weather event occurring in a specific location. The weather event and the location are the set parameters that must come together, and the threshold is most often depicted as wind speed, Richter scale, precipitation like rainfall or hail, daylight hours, etc., that must be met in order to trigger indemnity payout.

Application in the Agriculture Industry

Historically, parametric insurance has existed in the form of index insurance in the agricultural industry. Agricultural producers have been able to protect their fields and crops via Hail Index Insurance, Rain Index Insurance, etc. For example, if a farmer located in Purcell, Oklahoma, purchases a Rain Index Insurance policy to protect their wheat crops and then the rain index threshold is met for McClain County, our Purcell farmer will receive a payout, even if his field did not experience damage. The payout is triggered solely by the amount of rainfall experienced in the given location crossing the county’s historical data index threshold. Be aware, that can happen for either too much rainfall or too little rainfall, depending on the terms of the farmer’s index insurance policy.

Use in Other Industries

The same concept is being developed for use in other industries as well. Tourism and Travel have been using parametric insurance for years to help vacationers insure against rainouts, and poor weather conditions on their trips. The Construction Industry has seen parametric insurance products made available as a complement to Builders Risk policies, able to insure against high winds that may shut down crane operations causing completion delays and added expense.  The film industry can seek coverage against cloudy conditions and decreased daylight hours that cause production delays. Renewable energy can now insure against too little solar radiation, or windspeeds too slow to move turbines.

Indemnity Payouts

Indemnity payouts are automatic once triggered with a parametric policy. The event occurring in the agreed upon location, plus meeting the threshold criteria is what triggers payout. Damages and loss are not taken into account, meaning indemnity comes to the policyholder swiftly. Since  coverage is not related to damage, indemnity monies can be used for any financial shortfall experienced in the wake of disaster. This swift and discretionary payout allows monies to be used for business interruption, increased expenses, or property damage in the immediate wake of a disaster. No time is lost to field adjustments, estimates, and valuations. Just event trigger, then automatic payout. This streamlined claim and payout process can really sustain an insured’s cash flow and diminish weather vulnerability.

Flexibility and Customizability of Parametric Insurance

The flexibility and customizability of parametric insurance means a policy can be proposed for nearly any situation where historical data exists. Policies can be written on a single-year or multi-year basis covering the duration of extended projects. If historical data exists for an event type and potential damage magnitude, a parametric policy can likely be negotiated. Also, because all parameters, thresholds, and payouts are predetermined and mutually agreed upon, policy seekers can acquire a policy that suits their risk management budget.

Drawbacks to Parametric Insurance

There are drawbacks to parametric insurance though, namely basis risk. The predetermined indemnity amount may equal or exceed damages incurred. Or, indemnity may not equal up to the insured’s experienced damages. In a worst-case scenario, this can mean the policyholder experiences damages totaling greater than payout. This is a great reason to seek parametric insurance either as an additional form of coverage, or as coverage where there currently may be none available.

Coverage in Disaster-Prone Areas

Parametric insurance also makes coverage available in areas and scenarios where standard coverage is not available. We all know finding coverage for anything in Florida has been increasing in difficulty in the past years. Carriers who have had to pull out of disaster-prone areas may begin to market parametric policies in those areas as a way to regain a portion of those lost markets. With increased extreme weather in our global forecast, it is my prediction that parametric insurance is ripe for exponential growth across a multitude of markets in the coming decades.

For more risk management resources, contact INSURICA today.

This is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel or an insurance professional for appropriate advice. 

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