Coverage Corner

PARAMETRIC INSURANCE: WHAT IS IT AND HOW CAN IT HELP YOUR CLIENT?

By Cathy Trischan

Traditional property or business income insurance responds when there is direct damage or loss to property by a covered peril. Property insurance is based on the principle of indemnity, the idea that insurance should restore the insured to the financial position they were in prior to the loss. When a claim is made, the insured must quantify the loss and support the amount claimed. The claims process takes time and can be difficult for many policyholders, especially in the case of a complex business income loss.

Parametric insurance is different. Its trigger is the occurrence of a specific event such as an earthquake, flood, or hurricane. Coverage can even be written to cover perils not normally covered by property insurance, such as heavy rainfall or lack of rainfall. Parametric insurance is sometimes referred to as index-based insurance because coverage is tied to an established index. The index must be one that is objective and transparent and typically involves data available from an independent agency such as the National Hurricane Center’s Saffir-Simpson Scale or the US Geological Survey’s (USGS) earthquake magnitude readings.

Premiums for parametric insurance are based on the likelihood of an event happening, rather than the characteristics of the insured’s property. Payment of the claim is quick. Once the index threshold is reached (e.g., hurricane of a certain minimum wind speed within a defined area), the insured who has suffered financial loss receives payment without going through a claims adjustment process. The policy is often structured with different amounts payable at different thresholds. A higher amount might be paid, for example, for a category 5 hurricane than for a category 4 hurricane.

Parametric insurance does not replace traditional indemnity-based insurance but can be written to complement it. Consider the following example:

A large construction project is insured using a Builders Risk policy. If high winds cause damage to the project, Builders Risk responds as wind is typically a covered cause of loss, and the project has been damaged. Coverage may even apply to lost income and additional expenses due to the delay in completion of the project.

What if there is a delay in completion of the project due to the high winds, but there is no damage to the project? What if construction must be stopped for ten days because cranes and other equipment cannot be operated in the high winds? Or perhaps construction is paused for two weeks due to heavy rainfall? In both of these examples, Builders Risk will not respond because there has been no damage to the property by a covered cause of loss. Parametric insurance, though, can be written to cover the exposure. Specific weather triggers are named in the policy, and when the trigger is reached, the limit is paid.

Parametric insurance can also help the insured who has sublimits or high deductibles for certain causes of loss. Consider the following example:

A department store with a $20,000,000 replacement cost is insured under a property policy. The policy includes coverage for earthquake damage, but the deductible for earthquake losses is 5% of the building limit ($1,000,000.) Parametric insurance can be written with a trigger tied to USGS’s calculation of the magnitude of the earthquake within a specified distance of the store. If the trigger is met, parametric insurance pays the limit which the insured can use to help offset the deductible. Because payment is not tied to direct damage to the property, the insured is paid even if the store does not sustain significant damage. The insured can use the funds to replace some of the income lost due to reduced foot traffic after the earthquake.

Parametric insurance can help provide an insured with payment for losses not typically covered by insurance. We saw examples of this in our Builders Risk scenario, but here are a few other ways that parametric insurance can help a business.

▲ A hotel in a beachfront town is concerned about loss of income if there is extreme rainfall that causes a decline in tourism.

▲ A retail store chain specializing in imported specialty foods is concerned about loss of income if its supply chain is disrupted due to specific weather events in another part of the world.

The parametric insurance market continues to grow. Although parametric insurance is not currently purchased by most businesses, it is easy to see the benefit. These policies can be a valuable tool for independent agencies to consider when putting together insurance programs for their clients.

‘Til next time

Cathy Trischan, CPCU, CRM, CIC, ARM, AU, AAI, CRIS, MLIS, TRIP is IA&B’s commercial lines education consultant. She works with our CIC and CISR programs, as well as our live CE webinars. Catch her at one of our upcoming courses: IABforME.com/education