In a world where climate change has been impacting almost every aspect of our lives, the insurance industry is slowly but steadily pivoting towards Parametric or Index-based insurance solutions.

In the past decade, Parametric insurance was thought of as a fancy solution that was ‘too innovative’ or even ‘too expensive’, with most brokers and clients having little understanding of how it works. Today, most major insurance brokers now have in-house teams that specialize in parametric insurance in their organization.

What is Parametric Insurance
For Parametric insurance cover, pay-out is triggered by a pre-agreed event rather than physical damage which needs to be assessed and verified by a Loss Adjuster. Covers are structured using historical data for a specified weather threat, where a wide range of indices can be deployed subject to availability and data quality (eg. Rainfall, Wind speed, Humidity and Temperature).

Since the pay-out is determined through third party data, effectively no proof of damage is required. Consequently, there is no loss assessment and the claims process is much faster than traditional indemnity insurance which could take months or even years in some cases.

Agriculture
Globally, climate change is hurting agriculture with the increasing frequency and severity of threats ranging from floods to droughts, hail to frost, typhoons to bush fires. A move towards adopting parametric solutions will help mitigate risks in a more effective manner.

In particular, many farmers in Asia are uninsured from natural catastrophes and bad weather events. The existence of large protection gaps poses serious problems for both corporates and smallholder farmers.

Traditional indemnity insurance covers have often struggled to offer applicable and affordable insurance coverage, to tackle complex weather-related and other market related risks such as price fluctuations. For example, the policy wordings in traditional Multi-Peril Crop Insurance (MPCI) commonly contains high deductibles with multiple exclusions, and requires a tedious claims process.

Parametric solutions address many of these issues. Apart from standard weather-related covers, parametric insurance can protect against drop in yields where the index utilized is government yield data. This is commonly known as Area Yield Index.

Renewable Energy
In late December last year, The Guardian reported that UK power prices hit record levels as an icy cold snap and a fall in supplies of electricity generated by wind power combined to push up wholesale energy costs.

Spain’s Mequinenza Hydro plant, which has been in operations since 1966, ceased functioning in mid-

November 2022 due to drought causing water levels to subside to below 23 percent of capacity.

These are clear recent examples where parametric insurance could have provided cover for the lack of wind in wind farms and the lack of rain in hydro plants respectively. Even solar farms can be covered for lack of sunlight using a parametric solution.

Basis Risk
It is important to acknowledge that Parametric covers have a downside which is the existence of Basis risk. Simply put, Basis risk occurs when a loss event has poor or no correlation with the index employed, that is, a loss occurs but there is no pay-out as the trigger is not achieved.

almost every few months a new parametric product hits the market. With increased funding entering the parametric insurance sector, there should be more innovative products introduced in the coming years

In reality, Basis risk is generally unavoidable in any insurance solution. The challenge is to limit Basis risk. In fact, Basis risk is present in indemnity solutions. For instance, improper structuring of the policy coverage can lead to Basis risk.

Here is an example of Basis risk in a parametric solution:

The data of a designated weather station is used to determine pay-out for drought. If the weather station is too distant from the insured’s plantation, the data might not correlate with the actual weather conditions experienced by the plantation. It could be raining near the weather station and the data would not reflect drought conditions suffered by the plantation. The end result is no pay-out and the plantation suffers uncompensated drought losses.

Steps must be taken to reduce the amount of Basis risk in parametric insurance covers. Each solution needs to be rigorously studied and a strong correlation between the index and the risk needs to exist for lowered Basis risk.

The Future
Myriad number of possibilities exist for the application of parametric insurance, especially when combined with newly emerging technologies (eg Blockchain, AI) and new data sources (eg. Drones, IoT sensors). Solutions can also incorporate pricing data. In China, there is a growing trend for 'Futures + Insurance' type of parametric covers which takes into consideration both the price from futures markets and the yield data of the crop.

Application of parametric insurance is only limited by the quality & availability of data and the index structure that is developed.

Conclusion
Parametric Insurance is definitely here to stay. In fact, almost every few months a new parametric product hits the market. With increased funding entering the parametric insurance sector, there should be more innovative products introduced in the coming years. It’s definitely a space to watch!