‘All or nothing’ parametric policies can ‘cause problems’ despite benefits

The use of parametric insurance has grown exponentially in recent years - a trend that looks set to continue.

For example, a report published by market research firm Allied Market Research in May 2022 – entitled Parametric insurance market by type, by industry vertical: Global opportunity analysis and industry forecast, 2021-2031 – found that although the global parametric insurance market was valued at $11.7bn (£9.67bn) in 2021, this figure is predicted to increase to $29.3bn (£24.2bn) by 2031.

The represents a compound annual growth rate of 9.9% between 2022 and 2031.

Parametric insurance policies present an alternative risk transfer proposition that is provided by insurance and reinsurance companies.

These policies revolve around a measurable index and are based on event triggers predefined by the policyholder – once the set trigger has been hit, an instant claims payout is generated. This mechanism does not necessarily need physical damage to occur for a claim to be triggered.

The popularity of parametric or index-based insurance policies is due to the usually straightforward nature of the contracts, which offer a guaranteed, direct payout after a qualifying event.

These claims typically don’t require a loss adjuster’s involvement and can, therefore, be faster and simpler to settle than claims which are made on a conventional insurance policy.

Parametric policies can also prove useful to fill protection gaps if a traditional policy is unavailable or too expensive for the policyholder.

Insurers can benefit too – administrative costs on parametric covers are often lower versus other types of policies.

Claudio Saffioti, research manager at Marsh McLennan Advantage, explained: “[The] success [of parametric insurance policies] has been driven by the need to narrow very large insurance protection gaps [that] still [exist] in many countries.

“Parametric insurance can help extend coverage to high risk assets and communities and contain the risk of uninsurability.

“[Parametric policies] can prove particularly valuable in situations where traditional insurance markets lack the capacity or willingness to provide coverage.

“This is especially true for risks that are frequently underinsured or uninsured, such as floods, or where business interruption losses are more significant than the direct costs of physical asset damage.”

The cover also aims to offer transparency, as payouts and terms are explicitly defined, as well as greater accessibility, Saffioti added.

Basis risk imbalances

However, parametric insurance is not the new wonder child of the insurance sector – market commentators do note a number of disadvantages to the policies that counterbalance the positives.

For example, policyholders could experience a total loss event, yet could miss out on compensation if their parametric cover was not triggered for whatever reason. The flip side of this is if the claim payout exceeded the damage sustained in the triggering event. This situation is referred to as basis risk.

Adam Strong, partner in law firm Holman Fenwick Willan’s insurance team, said: “Because it is an all or nothing policy, there is a risk that the modelling might be wrong or the identified trigger might be wrong. You can easily see how either of these can cause problems.

“It is about the way things are worded. History is full of things that caught people out - look at the Covid-19 pandemic and the non-damage business interruption litigation that’s currently taking place across the globe.

“Evidently, the sellers of the policies thought they were selling something that they were not and the buyers thought they were buying something that they were not.”

Litigation concerns

According to Strong, the growth of parametric insurance also brings about an increase in the risk of legal disputes if there is a lack of clarity on the trigger event or how to define an industry loss.

This has further heightened the scrutiny of insurance contracts and wordings.

He explained: “History teaches us that whenever we think we have nailed something and it’s impossible for it to go awry, it does. Certainly, if there’s enough money at stake, people can be quite creative.

“You can also see the potential for satellite litigation. Not between the policyholder and the insurer, but perhaps involving the modeller. Has the modeller made mistakes in developing the model, put the wrong inputs in, made the wrong assumptions?

“Another [target of possible litigation] is the broker. Some policyholders are not particularly sophisticated and so the broker is guiding them through the [insurance purchasing] process. Is there any exposure there when there’s something that’s missed?”

Strong advised that to avoid disputes or litigation, it is vital to keep the parametric policy’s trigger mechanism as simple and straightforward as possible. In addition, policies should be governed under a jurisdiction with a sophisticated legal system.

Saffioti concluded: “Parametric solutions should be based on objective, verifiable data made available by reputable institutions. Such data should be easily understood by all parties involved.

“It is also critical for [parametric policies] to be based on a transparent and consistent methodology, to provide clarity on how payouts are triggered and calculated.

“Historical data analysis can be used to identify relevant triggers and ensure they are appropriate for the specific risk being insured.

“Before being made available in the market, solutions should also be tested to understand how they would perform in different circumstances, to make sure they are effective in providing coverage and to minimise basis risk.

“All stakeholders - including the insured party, insurers and brokers - should have a say in the design of the payout triggers to ensure they are agreeable to all parties.”