One of the main characteristics of the insurance sector is to anticipate the risk events to which society is always subject. In this way, the social need that insurance offers the consumers and the economic development of the insurance sector are met.
As the BDS (INESE’s daily insurance bulletin) reports, the insurance sector is booming. Spanish insurance could grow by an average of 5.3% per year until 2027. As a result, new products are continually appearing that take into account the particularities of the markets and the new solutions provided by new technologies.
In this sense, the so-called «parametric insurance» is a product linked to the management of large risks and to simplifying both the contracting and the evaluation and settlement of claims.
What is parametric insurance?
Parametric insurances are those in which the insurance company pays the compensation to the insured exclusively according to the intensity or production of a claim. The amount of this compensation has been previously calculated through a model or algorithm, considering the data handled by the insurance company itself.
This definition may seem somewhat complex, but it is not and, in fact, this type of practice has been developed for years in different areas of insurance, and more specifically in reinsurance, the management of large risks, or atmospheric phenomena.
All insurance clearly delimits the identity of the insured and/or beneficiary, the insured risk, and other issues such as the geographical area in which the insurance is effective.
Parametric insurance works in the same way, with the difference that in the case of the occurrence of the insured risk (a future and uncertain event), the beneficiary is automatically paid a previously established amount.
For example, in the case of torrential rainfall exceeding a certain volume in a certain place, or winds exceeding a certain speed in a certain place, the beneficiary will be paid the preset amount.
There are two fundamental differences with the way traditional insurance works:
– First, the payment of compensation takes place automatically when the insured risk occurs, regardless of whether the insured has suffered damage, and regardless of the extent of the damage.
By way of example, let us consider that a parametric insurance policy establishes that in the event of a rainfall of more than certain millimeters in a city, or winds with a speed greater than a pre-set speed, the beneficiary will be paid a compensation of, for example, 30,000€.
It is possible that this intensity of precipitation, or these winds, may occur and the client has not suffered any damage. Equally, it is possible that the risk occurs, and the damage or loss suffered by the client exceeds this amount.
The novelty of parametric insurance is that both the risk and the indemnity are previously established, and do not depend on the reality of the damage, but on the algorithmic (parametric) calculation already made considering all the data handled by the company to make an adjusted calculation.
– On the other hand, to determine the occurrence or non-occurrence of the risk, it is necessary to turn to an independent third party whose authority is recognized and not disputed by all interested parties. Thus, in the case of atmospheric risks, public meteorological agencies, or similar institutes (in the case of Spain, the AEMET) can be used.
What are the advantages and disadvantages of this type of insurance?
We wonder why both insurance companies and clients would accept a model in which the company may have to insure, even though the damage has not occurred or, seen from the opposite side, the agreed compensation may be lower than the actual damage. The advantages of this type of model can be summarized basically in the immediacy of compensation and the reduction of associated costs and security.
– Immediacy of the indemnity, once the occurrence of the risk is certified, the payment of the indemnity is automatic. It is not necessary to declare the claim or wait for the damage to be assessed.
– Reduction of associated costs, which is linked to the above. The way traditional insurance works not only generates considerable time delays, but also costs for all concerned. In parametric insurance, since a pre-determined compensation is paid at the moment the risk occurs, there is no need for an expert opinion, no need for processing or litigation.
– They are also safer because the insured knows beforehand the amount that he/she is going to receive if the risk occurs, and this has allowed him/her to evaluate whether the policy is attractive or not. There is no longer any uncertainty as to whether and how much the company will pay out in the event of a specific claim.
– On the company’s side, indemnities can be calculated more and more closely, and it also allows them to know in advance the expense they are going to face when a certain claim occurs.
– Finally, the possibility of insurance fraud is reduced, since the event has or has not occurred, and this will be certified by an independent official authority.
On the downside, it should be noted that the response of traditional insurance to the occurrence of a claim is much more tailored to the reality of the specific case and, often, to the needs of the client.
What are some possible applications of parametric insurance and what is its current situation in Spain and the world?
Although, as we said, this type of solution has existed in the field of reinsurance and large risk management for years, the reality is that its widespread use is still at an embryonic stage.
The very nature of parametric insurance makes it ideal for atmospheric or climatic risks (hurricanes, earthquakes, floods). Spain is not a country that stands out for its large number of these types of events, and perhaps for this reason we have seen greater development of these insurances in Latin America, and in the United States too.
In Spain, they will have a place in risks such as forest fires or agricultural losses caused by climatic events.
Other areas in which parametric insurance has a potential application are:
– New technologies. There has been talk, for example, of the possibility of pre-determined compensation if a creator of content on social networks (the so-called «influencers») has his or her account hacked.
– Renewable energy: this is a booming sector, and large companies are involved in the generation of energy from sources such as solar or wind power.
– Tourism and hospitality: can be strongly influenced by climate risks. Floods, earthquakes, volcanic eruptions, or similar events can lead to a surge in travel cancellations to the affected location, resulting in millions of dollars in losses for the local tourism industry.
Conclusion: Parametric insurance has an interesting future because of the significant advantages it offers, mainly immediacy, reduction of associated costs and security or lack of uncertainty for the insured and the insurer.
However, its disadvantages are also considerable, and it is still in an initial phase in which the calculations are still complex and not yet automated, so we will have to pay attention to its evolution over time.