Parametric insurance: what is it and how does it work?

Bespoke policies that function according to how the customer behaves or insurance that switches on and off are trends that are out there. Little by little, they will likely become pervasive in our lives and change the relationship that customers have with this industry.

Recently, a new concept has begun to emerge: parametric insurance. Certainly, this isn’t news for professionals in the sector, especially those involved in reinsurance, major risks or those who work with atmospheric phenomena. They have been around for more than two decades, but the general public may not be so familiar with an idea that, perhaps in a far-off or not-so far-off future, may become a reality. Today it is still a trend that needs exploring, because some of the attempts that have been made have not turned out so well, and they have remained precisely that: trials or projects with a very short life span because they failed to yield the expected results.

But, let’s start by defining what parametric insurance is. It’s a policy in which the insurance company pays the customer according to the intensity of an event and the amount of the loss. This is calculated using a model based on previously supplied data. It may sound a bit technical, but it’s not really that complex. Maybe an example will make it easier to understand.

The first step is to define the parameters to be used for the insurance to become operational. For example, we have to establish the specific geographic area to be covered by this insurance, in addition to other parameters such as the wind speed that must be exceeded for this policy to come into operation, the amount of liters of precipitation that must fall, the intensity of an earthquake, etc., and this is where objective and neutral information source comes into play to assure this data. In the case of parametric insurance, there is an indisputable third party. That is, one that is neither the insurance company nor the customer, but a party that is recognized by both, and by society in general, as an objective and neutral source of information that provides this data to determine whether or not the contracted coverage is activated. For example, the Spanish State Meteorological Agency in the case of weather-related parameters. This type of insurance would come into operation as soon as these parameters are met and no one will question the official information provided by such a body. As soon as the wind force exceeds the wind force specified in the contract in the planned area, for example, the insurance comes into operation, regardless of whether or not the customer suffers damage and where the customer need not be the one to report such a fact.

That is the main difference with what we might deem to be “traditional” insurance. It may be the case that, despite the occurrence of a major hurricane, some buildings in the area covered by the parametric insurance have suffered no damage. However, the customer would be compensated as the specifications have been met. However, damages may happen and they might be substantial and greater than those envisaged in the parametric insurance policy. What would happen then? The customer receives the agreed compensation, regardless of the damage. It could even be the case that damage occurs without the insurance having been activated, since the parameters set in the contract have not been attained. This is another major difference vs. traditional insurance, in which compensation is based on actual damages. Therefore, in same events, the difference in compensation between one policy and another may be significant.

Like everything else, it has its advantages and drawbacks. The main advantage is that the possible impact can be assessed in advance and the insurance companies’ forecasts are more accurate and it is known immediately if the insurance comes into play as soon as the circumstances envisaged in the policy arise. Other significant advantages may include a considerable reduction in claims management and administration costs, together with speed, allowing for much faster payments and time savings.

As the indemnification is triggered automatically, usually in real time, sometimes this mechanism has been set in motion even before the customer is aware that an event has occurred that triggers this policy. For example, in the event of a flight cancellation or delay, the insurer is often aware of the situation before the passengers. “Your flight is going to be delayed. Enclosed you will find a VIP lounge pass and a food and beverage voucher. Relax and watch for flight updates.” A message of this kind, for example, can make the situation more bearable. This would be an example of how a parametric insurance policy is activated.

Along the same lines, time is precisely one of the “drawbacks” of traditional insurance compared to insurance of this kind, since it requires an on-site assessment of the claimable event, which means that professionals have to travel to the site and examine all the claims. On the other hand, it is more in touch with reality. One advantage of traditional insurance is that, unless the customer wishes otherwise, the insurance company will usually repair claimable events rather than indemnify, an approach that customers rate highly.

This type of insurance is mainly used for risks related to natural phenomena (hurricanes, floods, etc.) and is not yet widely used or popular among private customers. Startups are the ones that are beginning to develop this type of insurance for individuals. They are using data analytics, new technological measurement devices, automation of risk assessment and new technologies, such as Artificial Intelligence or blockchain.

Social networks is another area in which this type of insurance is beginning to develop. For example, there are parametric insurance policies that are activated in the event of usurpation of the Instagram accounts of influencers. In such cases, a specialized company monitors the account activity and is able to detect the usurpation even before the user is aware of it. The following would be an example of how this kind of insurance works: a message is sent to the influencer alerting them that the usurpation has been detected, that procedures have been initiated to recover the account and that compensation has been paid for the losses incurred because the account is inactive.

Some projects launched for individuals focus on travel insurance, using parameters such as the cancellation or delay of a flight, a ferry or the loss of baggage at an airport after a certain predefined time after the flight has landed. It is not surprising that the area in which these new policy types are being tested is travel insurance. It is a market with great potential, as in Europe alone travel insurance will account for more than $10 billion in 2027, according to data from Allied Market Research.

Although some voices are predicting significant growth of parametric insurance in the future, initiatives in this direction are still at a too-early stage to be able to know with certainty how they will develop. In fact, some of them have not been as successful as expected and have ceased to exist after some time. But who knows if they will become commonplace in the future?

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