[co-author: Sophie Warren]
Parametric insurance products can help to address the increasing protection gap arising in respect of climate-related physical risk. As AI and data-collecting technology develops, more business areas may stand to benefit from the efficiency of parametric cover both in relation to climate risks and other – more traditional – risks.
Natural catastrophes and the "insurance gap"
Increases in frequency and severity of climate change and weather-related insurance claims have driven up premiums and, in some areas, seen insurers and reinsurers pull out of the market altogether, leading to the need for Government-backed solutions.
For instance in the UK, Flood Re was established as a joint initiative between the UK Government and insurers to make flood cover more available and affordable for at-risk homes. Whilst in the EU the European Central Bank and European Insurance and Occupational Pensions Authority ("EIOPA") have recommended a public and private sector reinsurance collaboration, and to establish a mandatory EU fund to pay reconstruction costs for large-scale natural catastrophes. This proposal was made in a paper published in 2023 on the current insurance gap, which noted that only around one quarter of losses caused by natural perils are insured in the EEA. Currently, Belgium, Denmark, France, Romania and Spain have established national catastrophe schemes at a national level; for instance pooling premiums and claims related to high risks across all insurance companies in the country (Belgium) or by legally mandating insurance cover against earthquakes, floods and landslides for domestic companies (Italy). However, these solutions rely on the impetus and intervention of the relevant authorities, and provide only limited cover.
Parametric insurance as a solution
Parametric insurance offers an alternative route to address the protection gap; it covers the probability of the occurrence of a peril, rather than indemnifying the actual loss suffered as a result, with claims being paid where pre-agreed threshold conditions are met against the relevant metric (normally measured using a public index). As a result, parametric insurance can deliver funds to insureds much more quickly than traditional insurance (which requires the loss to be adjusted). This index-based model has also been deployed in performance-based funds and structured products (including weather derivatives as a risk management tool).
An example of parametric insurance in practice:
- A maize farmer in Kenya is priced-out of the insurance market or otherwise unable to obtain cover.
- Farmer purchases a parametric drought insurance policy that agrees a fixed payout if rainfall is below a specified level during growing season, as measured by an agreed satellite source.
- Satellite source identifies rainfall below the agreed threshold during the relevant period.
- The policy is triggered and the farmer automatically receives the predetermined amount.
Parametric insurance typically uses data provided by an independent, reputable third party, and relies on significant amounts of historical data for pricing and thresholds. Examples in the market include Swiss Re's Insur8, a parametric solution offering typhoon warning insurance for businesses in Hong Kong, the African Risk Capacity parametric drought insurance policies with the Republic of Malawi, and payouts to Caribbean nations following Hurricane Beryl in July 2024 as soon as nine days after landfall of the storm.
Parametric insurance solutions are not confined to climate risks though and are increasingly being used in other settings. For example, Parametrix, a parametric product covering service delivery, pays out to insureds where an insured system interruption occurs; market players such as Aon and Swiss Re now also offer parametric property damage BI cover, and Blink uses a parametric model to cover travel disruptions and lost luggage, to name a few.
Looking to the future
Uncertainty and changeability in foreign aid arrangements means parametric insurance will be key in geographically vulnerable areas, whilst evolving climate risks and impacts on supply chains (both in nature and location) could mean a growing role for parametric solutions.
As AI technology improves, more, higher-quality data will be available for parametric models both in relation to natural catastrophe or climate change related risks, and potentially for day-to-day corporate needs as well. For example, as smart products become more ubiquitous there is the potential for parametric solutions (for example home insurance products) using data from the insured's own devices.
Parametric products could also be used as an excess option, 'topping up' losses where policy sub-limits have been reached, or as a means of cutting-out considerations of conditions, deductibles or exclusions, instead relying on the binary trigger under the policy (that is, whether the agreed metric is reached or exceeded). This streamlines and expedites the claims process, as reflected in the payout times of existing parametric products already on the market.
Next steps
Expectations of parametric insurance are widening - the index information to support parametric solutions is growing; parametric use cases are broadening and insureds’ appetites for alternative, appropriate products either instead of or alongside traditional cover is growing.
[View source.]
