How parametric solutions are closing the insurance protection gap

One way for insurers and brokers to grow their businesses is by investing in designing parametric solutions for their clients, usually to cover risks not included in traditional policies. 

A recent Munich Re LinkedIn follower survey revealed that out of more than 200 respondents, 18% said they used parametric insurance to mitigate the effects of extreme weather and natural catastrophes.

So, what is prompting this growing appetite for parametric insurance? In a nutshell, Parametric insurance is based on an index that captures the risk of a trigger event and provides pre-specified payouts based on the event’s level of intensity. While mostly applied as catastrophe insurance for property damage sustained in events such as earthquakes and hurricanes, parametric insurance is now being applied to other cases.

While traditional underwriting of physical risks does not meet the reality of evolving extreme climate impacts, the same can also be said for cyber threats. According to the Allianz Risk Barometer 2024, cyber security is the top risk worldwide. This comes partly from the resurgence in ransomware but also the ever-increasing methods of extortion that keep pace with the accelerated growth of new technologies. Similarly intangible in nature as climate risk, cyber is unpredictable, complex and interdependent on a global scale. However, alternative risk transfer solutions like parametric insurance models can help combat cyber risk instances like business interruption due to a third-party IT outage.

While cyber security is a key concern among risk professionals, we will now examine some of the details around why parametric insurance has become so popular with climate risk in particular.

In its annual economic report for 2024, the United Nations outlined that there will be increasing climate disasters, high food prices and more extreme weather expected this year. In particular, it emphasised the need for strengthened global cooperation, particularly in areas like climate action and sustainable development financing. Without this: "developing countries (especially those that are poorest and most vulnerable) will not be able to protect themselves from the unfolding climate catastrophe."

This last point is illustrated by the protection gap that exists within the insurance world, with less economically developed countries often being the ones most affected. According to Swiss Re Sigma, natural catastrophes resulted in economic losses of $270 billion in 2021, yet insured losses stood at just $111 billion. More companies are looking for ways to fill in the gaps and due to its predetermined triggers, parametric insurance is a promising candidate. 

Why is this? Well, because of the difficulties insurers face in making progress into the uninsured and underserved markets due to inefficient business processes, the high product development costs have traditionally kept the insurance penetration relatively low. With a parametric model in play, it is easier for insurers to price risk and to offer simpler, more transparent products. Insured parties typically do not need to file a claim or show proof of loss, and the payout is automatic. Its popularity is undeniable, with examples like Brazil-based Newe, receiving $5.3 million USD investment in January to expand its parametric product range, that expects parametric to make up between 2.5% and 5% of its overall business at the end of this year, a substantial increase of 900%.

However, despite its numerous benefits, parametric insurance does have its limitations. One of the main challenges facing the product is the need for accurate and reliable data sources. Without robust data, insurers may struggle to accurately assess risks and set appropriate trigger thresholds. Additionally, the lack of standardisation across different industries and regions can make it challenging to develop parametric insurance products that cater to specific needs.

Similarly, improved data quality allows for added precision when it comes to determining parametric triggers. As it improves over time, parametric cover will ideally become more efficient and economic as a complement to traditional property coverage – especially where capacity and pricing issues continue in traditional indemnity markets.

One of the key themes arising from the protection gap is the lack of certainty when carrying out risk assessment. Better data being fed into parametric models means that businesses can then improve their continuity plans and therefore make better-informed insurance buying decisions. With better quality sensors and instruments that can enable continuous monitoring and better quality data, more innovative risk transfer solutions are sure to follow.

There’s still room for the awareness of parametric insurance to grow, especially beyond the natural catastrophe examples which are most prominent. The increased interest in parametric insurance underscores its pivotal role in addressing evolving risks and closing the insurance gap. However, it is important to remember that insurance solutions are only as effective as the data that underpins them.