Application of parametric insurance in principle‐compliant and innovative ways

• Author: Xiao Lin,W. Jean Kwon
• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/rmir.12146
• Date: 01 June 2020

Risk Manag Insur Rev. 2020;23:121–150. wileyonlinelibrary.com/journal/rmir

|

121

Received: 17 July 2019

|

Accepted: 6 May 2020

DOI: 10.1111/rmir.12146

FEATURE ARTICLE

Application of parametric insurance in

principle‐compliant and innovative ways

Xiao Lin |W. Jean Kwon

Maurice R. Greenberg School of Risk

Management, Insurance and Actuarial

Science, St. John's University, New York,

New York

Correspondence

Xiao Lin, Maurice R. Greenberg School of

Risk Management, Insurance and Actuarial

Science, St. John's University,

New York, NY.

Email: linx@stjohns.edu

Funding information

Lloyd's of London, Grant/Award Number:

#35829

Abstract

There has been a rise of innovative parametric in-

surance solutions in recent years covering a wide

range of risks and serving clients from individuals, to

businesses, and to governments. These parametric

insurance products cover risks that are otherwise

uninsured or underinsured, by simplifying product

design and reducing transaction costs. This paper

offers a comprehensive review of parametric in-

surance including a classification of the types of

contract and an overview of market practices. We

outline the benefits and concerns of parametric in-

surance in comparison with indemnity insurance,

and discuss the legal principle and regulatory com-

pliance matters. We then survey the current global

market and identify areas where insurance and re-

insurance companies can play important roles in of-

fering or supporting parametric insurance operations.

Lastly, we offer a case study on a type of parametric

insurance designed to cover earthquake risk in

California.

1|INTRODUCTION

The nonlife insurance market plays an important role in protecting members of society against

a wide array of risks. The contribution of insurance is so significant that all economic activities

can be said to depend on some form of insurance protection to maintain their financial and

operational sustainability and growth. Yet, not all risks are insurable and not all insurable risks

----------------------------------------------------------------------------------------------------

© 2020 The American Risk and Insurance Association

are insured. The issue of “protection gap”is significant in both developing and developed

economies.

Swiss Re (2018a) reports the protection gap—defined as the difference between economic

losses and insured losses—to be around $193 billion in 2017. It also reports that the growth rate

of economic losses outpaced the growth rate of insured losses during the 1991–2017 data period.

Lloyd's (2018) notes that the average insurance penetration of developed economies, such as the

Netherlands, South Korea, and the USA, is twice as high as some developing economies. But all

countries are underinsured to some degree. For example, the US National Flood Insurance

Program reports that almost 40% of small businesses never reopen after experiencing flood

damages, primarily due to a lack of insurance coverage.

The widening protection gap is partly affected by the prevailing political, economic, social,

physical, and insurance market environments (Holzheu & Turner, 2018). At the same time, the

gap exposes some inadequacy in the current risk underwriting and loss assessment practice as

well as insurance contract design. For example, insurers set minimum and maximum coverage

limits and exclude certain correlated risks so they can manage their risk portfolios efficiently;

insurers include deductibles and coinsurance requirements in the contract to reduce problems

of moral hazard and costs of small claims; insurers also implement rigorous underwriting for

effective risk selection and classification to reduce adverse selection problems, and conduct

comprehensive assessment of claims for verification of the covered loss and the existence of an

insurable interest. As a result, traditional insurance coverages come with a heavy loading which

can cause suboptimal or nonconsumption of insurance. The comparatively weak transparency

in risk underwriting/pricing schemes, delays in claims settlements and occasional disputes in

loss valuation may also induce lower‐than‐expected consumption of insurance.

Parametric insurance can offer a new opportunity to solve some protection gap problems

while making the insurance market more efficient in many ways. Parametric insurance, also

known as index insurance, refers to an insurance contract under which the insurer becomes

responsible for the payment of an ex‐ante agreed or scheduled amount once a parameter or

index has reached the contract‐defined threshold. The name “Index insurance”is commonly

used in earlier literature and is often associated with insurance against weather risks for the

agriculture sectors. The name “parametric insurance”is more and more often used in a broader

context. In this paper, we use “parametric insurance”to broadly refer to any index‐based

insurance. Any pure risk can be a candidate for parametric insurance as long as a statistically

significant correlation between the loss event and the parameter that has been selected can be

established. The insurers benefit from an immediate release of their capital holdings as para-

metric insurance claims are short‐tailed by design. Buyers of parametric insurance benefit from

an additional or new layer of insurance coverage and receipt of fast claim payments.

Parametric insurance can protect vulnerable populations in developing countries against

natural disaster and weather risks where traditional insurance is too costly or infeasible, in the

meantime reducing problems of moral hazard and adverse selection (Skees, 2012; World

Bank, 2005). Parametric insurance can be more flexible than traditional property insurance, as

the former can cover extra expenses and/or business interruption without requiring direct

physical damage to the property resulting from an insured event (Bertrand, Hershey, & Par-

naudeau, 2016; Skees & Murphy, 2009), which provides another way to reduce the gap between

economic losses and insured losses. In the climate space, for one, parametric insurance can

increase resilience against climate change impacts while providing price signals regarding the

level of risk (Collier, Skees, & Barnett, 2009); for another, parametric insurance has the po-

tential to replace legal liability as compensation for climate damages due to its unique contract

122

|

LIN AND KWON