What is parametric insurance?

Parametric insurance or parametric risk transfer is a type of insurance, reinsurance or risk transfer arrangement that does not indemnify the full loss for the protection buyer, instead paying a pre-defined amount when a pre-determined condition is met (typically a parameter, or parametric trigger, is breached).

As a result, the concept of a cedent is perhaps not as valid in the world of parametric insurance, hence the use of the term protection buyer instead.

As, with a parametric insurance contract, a party is buying a pre-defined amount of protection which will pay-out based on pre-defined terms.

The pay-out terms are the key here, with parametric insurance featuring a parametric trigger. Thus a trigger mechanism defines when the contract is to pay-out to the protection buyer. This trigger is typically based on parameters directly related to the risk that the protection buyer seeks to acquire coverage against, such as hurricane wind speed, hurricane minimum central pressure, temperature, rainfall total, geographic location of a storm etc.

There are a multitude of ways to design a parametric trigger for an insurance, reinsurance or risk transfer contract. The contingent nature of a parametric insurance contract, that it pays out only when defined parameters are recorded or experienced, makes the pay-out mechanism predictable and also rapid.

Predictability of pay-out and speed of pay-out are vital, providing certainty that when certain conditions are met a financial payment will be made. For some insurance and reinsurance companies, a parametric trigger policy is a valuable addition to their existing protection. For corporations, where the protection is not covering anything insured, parametric insurance is a viable alternative to traditional insurance, providing a way to secure protection against precisely the conditions that affect or threaten their businesses.

So, what is of the upmost importance, is an understanding of the conditions to be used as a trigger and how they relate to a potential financial or economic loss to the protection buyer. Once that is understood, a trigger can be designed that provides highly accurate protection, paying out just when the conditions occur that can cause losses, either insured or economic.

The parametric trigger is also utilised in catastrophe bonds, which can often protect against specific parameters being breached, such as earthquake location and intensity. Weather insurance is also often parametric in nature, based on actual weather conditions occurring, rather than an indemnified loss.

Finally, parametric insurance makes for a quick, clear claims process, with minimised chance of dispute as the parameters are pre-defined and loss adjusters are not required. However, selecting the right reporting agency or station, to provide the parameters on which the insurance or reinsurance trigger is based, is vital, as it needs to be reliable and trusted.

In the insurance-linked securities (ILS) market, investors like parametric triggers as they are easier to understand, transparent and make for easier portfolio diversification as well.

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