Natural catastrophes (NatCat) losses have always been a big concern for the insurance industry – and in recent years related losses have surged. The highest-ever insured losses from natural catastrophes occurred between 2017–18, amounting to US$219 billion, according to Swiss Re estimates.
The United States, alone, faced 4,400 tornadoes, hail, and straight-line winds in May 2019. In addition to loss from physical damage, these types of outbreaks might cause pure financial losses without damage to physical assets, or even trigger contingent business interruption.
Anyone who listens to the news these days is concerned about potential disasters and the resulting impact on their lives, properties, and businesses. Almost a third of business customers (31%) say disruptive environmental patterns will impact them significantly, versus 23% of individual customers, according to Capgemini’s World Insurance Report (WIR) 2019.
Traditional insurance policies indemnify on actual sustained losses and also cover losses pertaining to specific scenarios. Customers may not be covered for purely financial losses that do not involve any damage to physical assets. In case of a loss event, insurers need time to assess the damage to physical assets before disbursing claim payments. A tedious task for insurers, the long claim disbursement process often chips away at customer satisfaction.
Enter parametric insurance. Unlike traditional property coverage, parametric insurance does not indemnify the pure loss but instead issues a set payment upon the occurrence of an actual triggering event. Sometimes called index-based insurance, parametric coverage has been around for years, but now, a new generation of parametric policies is leveraging data science, sensor technology, and artificial intelligence to expand use cases.
Index-based solutions cover the potential magnitude of an event. The event acts as a trigger for a pre-agreed payout. For example, if the parametric policy is linked to a river’s water level, pre-agreed upon payouts would automatically be triggered based on the river’s level if affected by severe drought or flooding because of higher than usual rainfall.
Apart from complementing traditional insurance policies and enabling offerings for previously uncovered risk scenarios, the biggest benefits of a parameter or index-based policy are speed and transparency. Typically, third-parties track the index – such as national weather services for policies linked to weather – and the payouts are quick and conflict-free, facilitating a swift settlement.
While the most common parametric insurance products are for NatCat events or weather-related risks, parametric policies can be also be used to cover risks such as power outage, disease outbreak, regulatory decisions, or even cyber threats.
What do customers think about parametric products?
The high frequency of NatCat events has spurred keen interest in parametric insurance policies across the globe due to their benefits over traditional policies. What’s more, some insurance policies are too complicated for clear understanding by many customers.
According to WIR 2019, 35% of business customers are highly interested in parametric insurance, versus 16% of individual customers. The enthusiastic response of business customers compared to individuals is not unexpected because index-based solutions offer quantifiable opportunities for businesses to control risk exposures better, especially in the absence of loss or damage to a physical asset.
Adoption is on the rise across the industry
More and more traditional insurers, as well as InsurTechs, are exploring parametric offerings. One of the most common examples in personal insurance is that of flight delay insurance products, with companies such as AXA and Etherisc developing products that self-trigger, without requiring the first notification of loss (FNOL) from the customer.
Earlier this year, Swiss Re Corporate Solutions launched FLOW, a parametric insurance product, to offer protection against business interruption losses or increased costs caused by high or low river levels for European businesses. Global insurance giants such as AXA and Allianz have specific entities exploring parametric insurance products. 
The demand for parametric coverage will undoubtedly become more mainstream, as the range and impact of climate-related weather events become more severe and unpredictable. Parametric insurance could become an increasingly viable option for helping organizations build climate resilience and strengthen disaster response and recovery.
Developing parametric products
The biggest challenge in developing parametric insurance products is correctly correlating an index with historical losses, to limit the basis risk. The availability of an extensive repository of claims data helps. However, proficiency in the latest technologies, such as deep learning, IoT, space data analytics, and image analytics are no less important. These technologies offer immense support when it comes to accurate risk quantification.
According to the WIR 2019, while 55% of the insurers have implemented technologies such as machine learning, artificial intelligence, and advanced analytics to help accurately quantify risk, they trail in some critical risk-quantification capabilities. Less than half of interviewed insurers said they had skills to access real-time data or had collaborated with third-party databases for more accurate risk-quantification.
Also lagging was the adoption of automated risk assessment capability, critical for enhancing product speed to market and developing a competitive edge in underwriting and structuring new offerings, with less than 30% of insurers focused on it.
No doubt insurers must build relevant tools and techniques for growing capabilities around accurate risk quantification. At the same time, though, they should also strengthen skills in monitoring emerging risks and capturing customer expectations to cater to the increasing market demand for parametric insurance products.
 Swiss Re Institute, “sigma 2/2019: Secondary natural catastrophe risks on the front line,” Lucia Bevere, April 10, 2019, https://www.swissre.com/institute/research/sigma-research/sigma-2019-02.html
 Insurance Journal, “U.S. Tornadoes, Hail and Winds Reach Highest Levels Since 2011: Aon Report,” June 10, 2019, https://www.insurancejournal.com/news/international/2019/06/10/528741.htm
 International Travel & Health Insurance Journal, “Insurance policy wordings – too complex?,” October 22, 2018, https://www.itij.com/story/114842/insurance-policy-wordings-too-complex.
 Capgemini’s Top-10 Technology Trends in Property & Casualty Insurance: 2019 Report, https://www.capgemini.com/resources/top-10-technology-trends-in-property-casualty-insurance-2019/.
 Business Insurance, “Swiss Re offers parametric coverage for water-level risks,” Claire Wilkinson, January 9, 2019, https://www.businessinsurance.com/article/20190109/NEWS06/912326059/Swiss-Re-offers-parametric-coverage-for-water-level-risks.
 AXA website, “AXA launches AXA Global Parametrics,” March 9, 2017, https://group.axa.com/en/newsroom/press-releases/axa-launches-axa-global-parametrics.
 Insurance Business Magazine, “AGCS reorganises alternative risk transfer business,” Ryan Smith, October 10, 2018, https://www.insurancebusinessmag.com/asia/news/breaking-news/agcs-reorganises-alternative-risk-transfer-business-113398.aspx.