The Evolution of Parametric Insurance: Traditionally, parametric insurance has been used to mitigate natural catastrophe-related losses, but advances in data science and technology are creating new opportunities for such coverage.

• Author: Singer, Andrew W.

Unlike traditional property coverage, parametric insurance is a type of insurance that does not indemnify the pure loss, but rather issues a set payment upon the occurrence of an objective triggering event, such as an earthquake of a certain magnitude or a hurricane of a specific intensity. Sometimes referred to as index-based insurance, this type of coverage has been around for more than 20 years, but it may now be reaching a new level of popularity as organizations look for additional alternative risk transfer options.

One of the key virtues of such coverage is that it enables companies to deliver insurance more efficiently. With parametric insurance, you avoid lengthy claims investigations--basically, an index is triggered, a payout is made, no questions are asked, there are no disputes.

Parametric insurance is particularly effective at the country level, especially in regions like the Caribbean that are prone to natural catastrophes. For example, developed under the World Bank's technical leadership, the CCRIF SPC (formerly the Caribbean Catastrophe Risk Insurance Facility Segregated Portfolio Company) was founded in 2007 as the world's first regional fund utilizing parametric insurance to cover catastrophe-related losses. When Panama was added in January, it became the 21st member country. Each nation benefits from quick payouts even before actual damages are assessed, providing much-needed financial liquidity that is critical for recovery efforts. This was also the motivation behind the record $1.36 billion catastrophe bond issued by the World Bank last year, which relies on parametric triggers to cover earthquake risk in Chile, Colombia, Mexico and Peru.

While parametric insurance has the advantage of quicker payouts, there is one particular shortcoming: It does not cover the actual event loss, but rather the approximate loss. This introduces what is known as basis risk, where the trigger index does not perfectly correlate with the underlying risk exposure, resulting in a situation where a policyholder suffers a loss but does not receive payment. For example, a storm could destroy your building, but you will never get paid if wind speeds never reached the agreed-upon threshold. Basis risk and the potential for such shortfalls could be one of the reasons the actual amount of parametric coverage written to date remains relatively small.

The market may be changing, however. Advances in data science, sensor technology and artificial...