Insurance is one of the few industries that have remained largely unchanged over the past few decades at a low level: You suffer losses as a direct result of something going south, and you get paid by your insurer.
But that old model doesn’t always work. For example, a construction company in a region regularly affected by hurricanes might see its projects surviving these storms mostly unscathed, but it might still see losses in terms of time and other potential costs because crews simply couldn’t make it to work.
Your traditional indemnity policy might pay this company based on the magnitude of its losses but wouldn’t have to pay for those unforeseen, follow-on costs because they aren’t “damages” in the usual sense. One could argue the company is getting the short end of the stick here.
Parametric insurance, on the other hand, ensures that everyone can win. Instead of insuring customers based on the magnitude of the losses incurred, parametric contracts insure customers against the magnitude of events. So in our example, the construction company may see a payout if there is a certain “trigger event,” such as the area is hit by a Category 4 hurricane or higher, or if the wind speed reaches a certain, pre-specified mark.
Investor Nina Mayer, a principal at Earlybird Venture Capital, defined it quite succinctly in our recent insurtech survey:
Parametric insurance (as opposed to traditional indemnity insurance) is an insurance type that pre-specifies the amount of payout based on concrete “trigger” events. For example, the payout could be linked to a certain weather event, such as the height of a river above the flood point.
This type of insurance is also called index-based insurance because it relies on data and automation, a combination that explains why this approach is enjoying tailwinds. Instead of filing and reviewing claims, both parties can rely on information showing that a trigger event occurred.
Leveraging data in this way makes the process more efficient for both the insurer and the insured. “The key advantages of parametric insurance are fast payouts, high flexibility and the option to provide coverage for losses that are difficult to model,” Mayer said.
The fast payouts that this model facilitates make it particularly useful for weather-related insurance, where those affected are most benefited by quick access to funds. That is clearly evidenced by the number of insurtech startups building parametric solutions for this space.