Parametric Insurance: What It is and How It Works

The insurance industry is currently expanding, and new policies are being introduced to people. Product innovation and data analytics have also evolved over the years, ultimately providing solutions that offer coverage for a wide range of perils, exposures, and threats. Parametric insurance may be new to you, but it has been in existence since way back, and currently, it is one of the most sought-after insurance policies in the insurance landscape.

Parametric Insurance: What It is and How It Works

Recently, this innovative approach to risk management has gained popularity and fame due to its capability to provide fast and seamless payouts while also acting as an alternative to traditional insurance coverage. Parametric insurance offers transparent and fast claims payments that allow policyholders to request a payout without actual physical damage to a property or asset.

What is Parametric Insurance?

Parametric insurance, also known as index-based insurance, is a form of insurance that offers payment of a predetermined amount when certain terms and conditions are met.

Unlike traditional insurance, where compensation is given for actual losses incurred, parametric insurance payouts are primarily based on the contingency of a triggering event, which includes natural disasters or fluctuations in commodity prices.

How Does It Work?

The policies established by parametric insurance are based on certain parameters like rainfall levels, wind speed, wave length, magnitude of earthquakes, and other disasters caused by nature. In a situation where these parameters exceed the structured threshold, the policyholder will then receive a payout, regardless of the intensity of the loss incurred.

For instance, a parametric insurance company can specify in their policy for a hurricane that if wind speed is up to or exceeds 100 miles per hour, the policyholder will receive a payout of $100,000. The policy term largely depends on your insurance provider and the exact coverage you signed up for.

Parametric insurance covers a vast array of risks across different areas of the ad industry, such as:

  • Retail
  • Hospitality and leisure
  • Manufacturing
  • Finance 
  • Entertainment
  • Construction
  • Transportation and logistics
  • Health care
  • Energy
  • Agriculture

Advantages of Parametric Insurance

  • Quick Payouts: Since parametric insurance payouts are triggered by predetermined events that may occur as a result of natural disasters, the claim for this insurance can be processed with ease and as fast as possible, ultimately providing adequate funds to policyholders after the occurrence of a catastrophic disaster.
  • Transparent: The policies it establishes are usually objective in nature, ensuring transparency and accountability, making it easier for policyholders to have a better understanding of what the policy actually entails.
  • Risk Transfer: It ultimately grants businesses and individuals the opportunity to transfer specific risks to their insurance providers, who will then provide financial protection against potential events that can incur significant losses and damage.
  • Customizable: It can also be customized and tailored to meet the specific needs and preferences of the policyholder. This option allows policyholders to choose the exact parameters and coverage levels that are suitable for their risk exposures.

Disadvantages of Parametric Insurance

Every single thing that offers advantages will most definitely have its downsides. While we consider the benefits of this insurance policy, it is also essential to point out its downsides. Outlined below are some of the disadvantages:

  • Limited Coverage: It is not as comprehensive as you think, owing to the fact that it provides coverage only for specified events and parameters, which can expose the policyholders to a variety of risks and perils that are not covered by the policy.
  • Basis Risk: This simply denotes that there is every tendency that the triggering event predefined in this insurance policy will not perfectly correlate with the exact loss suffered by the policyholder. If you have parametric insurance that covers rainfall levels, it may not provide accurate coverage for the impact of a drought on agricultural yields.
  • Complexity: This is also one of the major downsides of parametric insurance that can make it difficult for policyholders to purchase parametric products. The design and implementation of parametric insurance policies can be quite complex and hard to understand. It requires careful analysis of historical data and risk assessment. This factor makes it time-consuming in a way, as it takes time for stakeholders to have a better understanding of how it works.
  • Traditional insurance resistance: It may lose its stance due to resistance from traditional insurance providers. Parametric insurance may pose a threat to the market share of traditional insurers and can ultimately hinder its adoption in the insurance industry.

All of these challenges can be tackled if there’s collaboration between insurance providers, regulators and stakeholders to set comprehensible guidelines that would provide solution to some of the challenges facing parametric insurance.

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