Parametric coverage is transforming the insurance industry by providing innovative and effective solutions to mitigate the effects of catastrophic events, which are becoming increasingly frequent and severe due to the impact of climate change.
The insurance industry is facing a constantly evolving environment, driven by the search for solutions adapted to the needs of current markets and the possibilities offered by new technologies. In this context, parametric insurance has consolidated as a key tool for large risk management and the simplification of processes, from contracting to claims settlement.
What is parametric insurance?
Parametric or index-based insurance covers the probability of a predefined event occurring, basing economic compensation on the verification of objective parameters. These parameters include quantifiable measurements, such as the amount of rain, the magnitude of an earthquake, or the speed of the wind. When the event reaches or exceeds the agreed threshold, the insurance is executed automatically.
This approach provides an agile and predictable response in high-risk situations, where the ability to respond immediately can be crucial to mitigate additional losses. Based on objective data, parametric insurance eliminates the need to conduct detailed inspections or assessments of damages, thereby accelerating the compensation process.
How does parametric insurance work?
The process of parametric insurance is articulated in a series of stages that ensure clear and efficient operation. These phases allow the insurer and insured party to establish, monitor, and validate the criteria necessary for the compensation to be resolved without delay.
- Definition of parameters. The insured and insurer agree to parameters and thresholds that will be used to activate the payment, such as the amount of rain or the magnitude of a claim.
- Monitoring parameters. During the coverage period, the parameters defined will be verified using objective data sources, such as weather stations, seismic sensors, or government databases, ensuring accurate measurement.
- Execution of the compensation. If the agreed threshold is met, the settlement is made, which will depend solely on the measurement of the agreed parameters rather than the actual damage.
Advantages of parametric insurance
Parametric insurance has numerous operational and financial advantages for both insurers and insured parties. Some of the most significant are:
- Agility in compensation. Since individual damage assessment is not required, compensation can be received in a short period of time, even in a matter of hours or days. This is particularly relevant in emergency situations, where the speed of the financial response is key to recovery.
- Predictability and transparency. The clear definition of parameters and pre-established thresholds eliminates ambiguities and possible conflicts over the extent of damages. Both parties know the conditions beforehand, which encourages trust.
- Coverage of traditionally non-insurable risks. It allows coverage of risks that are difficult to quantify with conventional insurance, such as certain geopolitical or market risks, by focusing on measurable and verifiable parameters.
- Reduction in operating costs. Automating claims and eliminating damage verification processes significantly reduce administrative costs, allowing for more competitive premiums.
- Accessibility in emerging markets. It has great potential in regions with little insurance infrastructure. In vulnerable areas, such as certain developing countries, it offers effective solutions for risk management.
The challenges of parametric insurance
Although innovative and effective, parametric insurance faces several challenges. One of the most relevant is “basis risk,” which occurs when the insurance compensation does not match the actual losses suffered. This may occur adversely, when there is a real loss, and the insurance does not take action, leaving the insured party without compensation. Conversely, there may also be favorable basis risk, where the insurance is executed without a real loss, generating compensation that could be considered an unjustified profit.
Minimizing this risk requires a precise correlation between parameters and losses. The quality and precision of the data used, as well as the analysis algorithms, are crucial for defining appropriate thresholds and avoiding unnecessary or insufficient payments. Furthermore, by not covering specific damages, the insured may be left unprotected if the event does not align with the agreed parameters, limiting their flexibility. For these reasons, parametric insurance must be conceived as a complement to traditional insurance and not as a replacement.
Examples of parametric insurance in different sectors
The scope of parametric insurance has grown exponentially in recent years, integrating into various sectors to respond to the needs of a world shaped by climate change.
- Agriculture: Especially useful for mitigating the devastating effects of phenomena such as droughts, frost, or storms, based on parameters such as precipitation or temperature, parametric insurance offers fast and predictable coverage.
- Catastrophic risks: In areas prone to disasters such as earthquakes, hurricanes, or flooding, compensation is automatically implemented when the magnitude thresholds are exceeded, facilitating a quick response.
- Transport and logistics: It protects supply chains against delays due to natural events, with insurance that covers interruptions based on weather parameters.
- Tourism and events: They are insured against cancellations due to adverse weather, based on conditions like heavy rain or strong winds.
- Governments and communities: Used to manage climate risks, it enables the financing of rapid emergency responses, stabilizing the economy and facilitating short-term recovery.
Future trends and opportunities
Emerging technologies, such as artificial intelligence and big data analysis, will improve the precision of parametric insurance. The use of IoT sensors and real-time data will enable the development of more robust and personalized models, reducing basis risk. Second-generation insurance, which uses local intensities calculated with geospatial models, is already beginning to offer more precise customizations in high-exposure contexts.
Collaboration between insurance companies, governments, and international organizations will continue to strengthen protection against risks arising from global warming. This synergy is crucial for facing a world where climate and economic uncertainty will continue to challenge predictability. In this regard, parametric insurance is designed as an indispensable partner for managing a future that is as promising as it is unpredictable.
