A fact that has been hard to swallow and often debated is that insurance is not available to cover every loss. There are various reasons for this – perhaps the loss cannot be modeled with any degree of predictability to enable insurers to set an appropriate rate for coverage, or the loss is not accidental in nature and could have been prevented, or the loss would be so widespread and catastrophic that insurers could never take in enough premiums to cover all the policyholder losses, which of course can be said of pandemics. The COVID-19 pandemic hit businesses and the economy hard, and policyholders were looking to their insurers to recoup some of their financial loss, regardless if coverage actually existed on the policy for those losses. Because pandemic coverage is nonexistent on standard insurance policies, the question arose as to who should (and how to) cover the various costs arising from COVID-19 and any similar pandemic in the future. However, this is just one issue – with growing climate change issues, there are stronger and more damaging storms, greater risks of flooding, increasing droughts and wildfires, and a host of other hazards that are difficult if not impossible to insure.
This is where parametric insurance enters the picture. Parametric insurance offers financial protection against losses that are often hard, or even impossible, to get insurance for, but in a nontraditional insurance structure. Traditional indemnity insurance, the kind we are all familiar with, pays out based on the cost of the loss incurred. Parametric insurance pays out when a predefined loss event occurs and the loss event exceeds a specific dollar or index amount that was agreed to in the policy. Examples of covered perils and typical triggers include hurricane (wind speed), flood (water height), earthquake (shake intensity), pandemic (number of infections), or cyber (reported data breach).
Take, for example, the Jumpstart parametric insurance that is being offered in California, Washington, and Oregon. Once an earthquake event occurs, the company will initiate messages via text to the insured or the insured can contact the company. Payments are issued immediately, although an insured is still required to complete a loss report form as soon as practicable, and no later than 60 days after the date of loss. Jumpstart may audit a certain number of claims after an event, and ask for receipts and photographs that substantiate an insured's claim.
A parametric policy can be viewed as an "objective" trigger. The trigger is set on the policy at the predetermined amount based on supporting data of prior perils and losses. Both the insured and insurer agree to this amount so it is a contractual agreement between the parties. The trigger set on the policy must correlate to the damage, so having supportive data is paramount.
Advantages to an insured are that because the insurer knows how much the policy is going to pay out prior to the loss, claims are settled virtually immediately and the insured gets paid out quickly. If the insured has the coverage and the flood or earthquake is at their premises, then the policy will pay out, regardless if there was actual damage, so the insured knows they will receive a payout once the peril reaches the trigger. The insurer knows exactly how many policies will be affected by a given peril, eliminating uncertainty. Therefore, the policies are less expensive to the insured, and the insurer has greater predictability of losses and can set rates accordingly.
As with any catastrophic loss, policyholders have an immediate need for cash to survive. Having parametric insurance would ensure they get the agreed amount almost immediately, which could mean the difference between survival and nonsurvival, particularly for small to medium-sized businesses. In general, the funds can be used for anything; they are not tied to additional living expenses or temporary repairs as in a standard property policy, so an insured has the flexibility to do whatever is necessary.
So what if the insured had greater losses than the predetermined amount? Well, this is where parametric insurance cannot be looked at in the same way as traditional indemnity insurance. It is not an indemnity policy–it is a trigger-based policy. The insured would bear his portion of the loss, but for many insureds, this concern is offset by the lower policy premium and the certainty of a specific dollar amount to be paid quickly. The insured very likely still needs a standard policy for many perils, but the parametric policy provides immediate funds without an insured having to wait for an adjuster to inspect the damage.
So where does the capital come from in a parametric arrangement? Parametric structures are attractive to capital providers from outside of insurance (hedge funds, banks, pension funds and dedicated investment vehicles). When they are designed properly, parametric-based insurance products ensure that claims are paid fast and without dispute. The event is covered at a predetermined amount for a preset trigger event.
Parametric insurance is a way to bring innovation into insurance. Parametrics open up opportunities to those that can build, or tap into, a source of reliable data, preferably with years of historical records, that can be used to create indices that correlate with financial losses. These can be particularly valuable if the data source is exclusive.
MGAs and brokers that are technology-based with clients struggling to get the insurance they need are starting to turn to parametric insurance. The concept has also been used for a number of years in microinsurance.
This is just the beginning of what we will be hearing about in the way of parametric insurance, as catastrophes increase and insurers seek more innovative ways to provide affordable coverage with greater predictability.
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