Parametric Insurance and its Growing Place in the Industry

Amidst ongoing climate volatility, Australian businesses can’t catch a break.

With escalating insured losses across Australia, particularly in the last half-decade (which included the 2018-2019 bushfires, the floods of 2020-2022, and hail and drought during 2023), many businesses struggle to obtain adequate insurance coverage and sufficient protection against natural catastrophes.

Parametric insurance has been established as one of the main approaches to alleviating gaps in the traditional market, offering unparalleled natural catastrophe insurance globally, and increasingly in Australia and New Zealand.

What is parametric insurance?

Parametric insurance is a specialised form of coverage designed to address the challenges posed by disasters fuelled by climate change and other emerging risks, like cyber.

Unlike traditional insurance, which relies on lengthy loss-adjustment procedures, parametric insurance operates on predefined, objective indicators. It pays out a pre-agreed indemnity amount when a catastrophic event occurs, triggering the coverage parameters set in the policy contract.

The key component of parametric insurance lies in the use of objective indicators, known as ‘parameters’, which serve as an accurate and reliable measure of the extent of natural disasters and emerging risks.

This can include the peak wind speed measured near the eye of a cyclone, the intensity of the ground shaking during an earthquake, or the highest river water height during a flood. If the parameter measures are met, the insured event is deemed to have occurred and the policy pays out a pre-agreed sum.

In the event of a cyclone, earthquake, flood, or other triggering event that meets or exceeds the predefined parameters, there is minimal further assessment or consideration (compared to traditional insurance), and therefore the impacted client will receive timely pay-outs, allowing for faster recovery and reducing financial uncertainty.

Parametric insurance solutions can also apply to the full financial impact of a loss event, including non-damage business interruption, lack of access, or reduced tourism attraction, which traditional insurance carriers cannot provide cover for in most cases.

The advantages and advances in parametric insurance

As parametric insurance has gained traction in the market, more corporations around the world are seeking parametric insurance.

Continuous data advancements and the emergence of new AI-driven technologies have led parametric products to be more robust, subsequently increasing buyers’ appetite. Incorporating satellite and radar technologies, machine learning and advanced physics into underwriting models has also enabled a more precise understanding of risks and a more granular approach to pricing to better incorporate the cost of climate change.

Likewise, because parametric products are priced based on the likelihood of an event happening, pricing remains stable following loss events, providing clients with an alternative to the frustrating volatility of traditional market pricing. What’s more, with the certainty of parametric products, vastly more of the premiums spent on coverage are returned to policyholders as claims, instead of being spent on frictional costs and disputes.

Additionally, traditional insurers’ claims management processes are lengthy (18 months to several years on average for most corporate clients), burdensome, and often disappointing as policy exclusions lead to misunderstandings on the client’s side (e.g., clients insured against epidemics were not covered against pandemics and did not receive any claim payment, despite losses related to COVID-19).

The growing need for a different solution

As climate change continues to evolve and new risks emerge, certain lines of business are struggling to find Natural Catastrophe (often referred to as ‘Nat Cat’) capacity, inspiring corporates to ask brokers to deliver parametric solutions to help mitigate the financial impact of natural disasters. The areas seeing the most traction include renewable energy, agriculture, manufacturing, tourism, construction, and the hospitality industry.

Regarding affordability, the bottom line is that any insurable interest affected by or exposed to Nat Cat and extreme weather events requires a different approach.

Adaptation relies heavily upon the sustainability of capital and its longevity. Parametric insurance may be viewed as an optimal solution as it applies agnostically to many industries and is much less concerned about the asset type.

Instead, the risk allocation between the insurer and the insured is fairer; each structure is fully tailored to the client and considers asset resilience and mitigation and any financial levers the insured already has in place.

This enables the insureds to address the broader economic impact a climate event has on their operations, clients, suppliers, and vendors, including financial exposures and non-damage business interruption, which is vastly under-insured by traditional carriers.

Finding the solution

Technology and innovation have become infused across various sectors yet insurance remains largely unchanged; the issue of natural catastrophes provides the perfect opportunity for the insurance industry to address this.

By challenging the status quo of traditional Nat Cat modelling, the actuarial community has the chance to evolve beyond the conventional ‘actuarial’ historical event models and begin integrating elements of physics into model constructions. This includes considering asset resilience and mitigation, alongside implementing thorough validation processes for these models.

Faced with the escalating impacts of climate change, resilience and adaptation are no longer merely desirable but essential.

The views expressed in this article are solely those of the author and do not necessarily reflect the opinions or policies of the publication, its editors, or affiliated entities. The information provided is for general informational purposes only and should not be construed as professional advice.

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