In recent years, climate risks have increased in intensity and frequency. Society's vulnerability to these risks has been growing through the combination of the effects of climate change, increased concentrations of property values, and fluctuations in the insurance market cycle, which has resulted in reduced coverage options and capacity, insurers exiting entire market segments as well as high-risk areas prone to natural disasters, and significant increases in pricing and deductibles.Most of these trend factors are unlikely to change dramatically. For 2024, the global insured losses from natural catastrophes totaled over $150 billion.
Each year, there are a few events that single-handedly bring utter devastation and catastrophic losses, such as the earthquake in Turkey and Syria in 2023 with more than $92 billion dollars in economic losses, of which only 6 percent were insured, and the severe convective storm events in the United States in the first half of 2024 followed by Hurricanes Helene and Milton.
Climate Change Calls for a Revolutionary Approach to Insurance
Faced with this phenomenon, insurers have been increasingly resorting to reductions in coverage or expanding exclusions and increasing pricing. A paradigm shift seems more necessary than ever in public policies as well as in the evolution of insurance techniques to better understand—and evaluate—climate and weather risks. Improved use of data and the development of "forward-looking" models are needed to create risk transfer products that are meaningful to protect a buyer's earnings and balance sheets.
What Is Parametric Insurance and How Does It Work?
While there is no one-size-fits-all solution, parametric insurance stands out as a tool well-suited to address some of these risks.
How It Differs: Trigger-Based Coverage Instead of Loss-Based Payouts
Parametric insurance differs from traditional options in that the product outlines predefined parameters linked to a triggering event (e.g., a hurricane or an earthquake), not the damage suffered. This parameter can take the form of any measurable event: shake intensity, maximum wind speed, barometric pressure, hail size, water level, and so on.
Clarity and Speed: Transparent Triggers and Fast Payouts
A parametric policy clearly states what is covered (and conversely, what is not covered) and is tailored to a client's actual needs, offering insureds the clarity of knowing what exactly is in their policy, how it triggers, and the payouts they will receive if a triggering event occurs.
Because the cover is based on a parameter (or index), parametric insurance does not involve a traditional claims settlement process and, therefore, offers swift payouts post-event (< ~30 days), allowing insureds to recover quickly.
The liquidity element offered by a parametric policy is especially important in an inflationary, high interest rate, and economically uncertain environment.
The Role of Data and Technology in Policy Design
Data plays a large role in how a parametric policy is structured. Parametric solutions utilize a variety of data sources, such as publicly available weather or earthquake data, satellite or radar imagery data offered by private companies, or Internet of Things devices, to name a few. These data sources, along with in-house modeling capabilities, provide crucial insights into the dynamics of natural disasters.
The more robust data that is at an underwriter's disposal, the better the understanding of climate and weather events and the better the quality of the ultimate risk transfer product. It is the fusion of technology and modeling expertise that allows the development of a more accurate product offering to the customer.
Testing Before You Buy: The Advantage of Backtesting
In addition, parametric insurance allows for the unique opportunity to "backtest" a cover. In other words, an insured can look at a past event and apply the proposed parametric policy to see how the cover would have paid out if it had been in place. This provides a significant difference in transparency versus a traditional policy. Backtesting is also a tool to test if a policy is accurately structured to a client's needs.
How Does a Parametric Policy Fit into a Larger Insurance Program?
No matter the client, from a large corporation to a midsized or smaller business, exposure to climate and weather risks can be significant. Here are a few different ways a company may be able to use a parametric product.
- To complement an existing program that doesn't meet a company's capacity needs
- As a standalone product to cover a peril otherwise excluded from existing coverage or too expensive to keep within a larger program
- To create an entirely tailored program for a set of tricky-to-insure assets (e.g., assets particularly prone to windstorms, hail, tornados, etc.)
- Parametric cover to "buy down" an increased natural catastrophe deductible
There are numerous functions for a parametric product. The following case studies lay out a few of the options, ranging from the more traditional uses to the "out-of-the-box" solution that only a parametric policy can provide.
Real-World Use Cases: How Companies Are Using Parametric Insurance to Stay Ahead
Case study 1: A hospitality client in need of hurricane coverage
- The problem: A hospitality client in Florida has several exposed properties, making both their physical and financial assets extremely vulnerable to a named windstorm.
- The solution: The client purchased a parametric cover with a linear payout starting at 25 percent of the limit for a Category 3 storm, 50 percent payout for a Category 4 storm, and a full payout in the event of a Category 5 storm. The full limit on the policy was $10 million, and the coverage area had a radius of 30 miles.
- The result: During the policy term, if a Category 4 hurricane were to pass the property within the 30-mile radius, the client would receive 50 percent of their limit, or $5 million.
Case study 2: An automobile operation looking for non-damage business interruption (NDBI) protection
- The problem: A US-based automobile client relies heavily on imported component parts from Japan. A sizable seismic event at the Port of Osaka could interrupt that supply chain, causing substantial economic and financial damage to the company.
- The solution: In order to protect their supply chain risk, the client purchased an earthquake cover for the Port of Osaka to cover their NDBI risk. The client purchased $20 million in coverage.
- The result: If the port were affected by an earthquake, a payout would immediately be triggered. For example, if a 6.9 earthquake were to occur with a peak ground acceleration (PGA) of 68 percent g¹, with a payout of 50 percent for any event over PGA 60 percent, the client would receive 50 percent of the payout or $10 million.
¹ A seismic g is a value that quantifies the seismic loading on a structure relative to its own weight.
A seismic g of 1.0 infers that a structure is experiencing seismic loads equal to its own weight.
Case study 3: A construction company finding cover for extreme heat delays
- The problem: A large construction company based in the Southwest is facing significant financial exposure from project delays due to extreme heat.
- The solution: The client purchased a parametric policy to protect their revenue losses of up to $4 million in the event of a heatwave with temperatures exceeding 108 degrees Fahrenheit.
- The result: If a heatwave were to occur with temperatures at 115 degrees Fahrenheit during the agreed risk period, the client would receive the full limit of the policy, or $4 million.
Case study 4: A technology company using a parametric policy to help its employees
- The problem: A technology company with a large workforce based on the West Coast is concerned that a sizable seismic event would adversely affect its employees. A significant percentage of homes on the West Coast are either underinsured or uninsured for earthquake damage.
- The solution: The client purchased a parametric policy of $20 million as a benefit to their employees. Once triggered, the proceeds from the parametric cover would be paid out to affected employees in an effort to help them recover quickly from the event and return to work—whether that be providing generators, temporary housing, or clean-up services.
- The result: During the policy term, if a seismic event with a PGA of 65 percent g was recorded, and the client had a payout structure with a 30-percent payout for any event over 60 percent PGA, the client would receive 30 percent of the full policy limit, or $6 million.
Integrating Parametric Insurance into Your Existing Risk Management Strategy
The fight against climate change is a multifaceted challenge; there is no single solution, but thanks to cutting-edge technology and an expanding product offering, parametric insurance has established itself as a promising tool in helping to build climate resilience. In the coming years, the products will continue to evolve to complement traditional products in the face of emerging risks or stand in where the traditional sector can no longer provide affordable coverage or coverage at all.
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