Parametric insurance is not new. However, its application is constantly evolving. Our construction specialist, Lauren Davies and parametrics expert, Richard Coyle explore how parametric cover could provide new approaches that complement existing, more traditional risk transfer strategies for your construction project.
What is parametric insurance?
Parametric policies operate differently to traditional insurance policies, as they are built around a pre-defined event for which payment is guaranteed should it occur. The insured does not have to go through a lengthy loss adjustment process in order to receive payment. Instead, the occurrence of the pre-defined event triggers the policy, and payment is made. As a parametric policy provides insurance against the probability of an event occurring, premium rates are based on definitive, objective and independently verified information. All this creates certainty for the insured to assist with financial and risk mitigation planning.
How would it apply to a construction project?
For example, an owner has engaged a contractor to undertake a building project in a cold climate. The works are programmed to take place during the warmer seasons to allow progress within acceptable temperature parameters. Any persistent unseasonal cold weather during this period will delay the works and may prevent completion until the next spring. A parametric policy could be designed to pay a pre-agreed settlement once a set number of contingency (or float) days have been consumed by temperatures below an agreed level.
What can be used as a parametric trigger?
Parametric triggers are normally linked to meteorological conditions, however other risks can be protected against too. The keys requirements are that the trigger is fortuitous and can be modelled statistically by the insurer. Examples include:
- Natural catastrophes and weather (e.g. earthquake, windstorm, storm surge, hail, flood, rainfall, temperature)
- Energy (e.g. solar radiation, wind, power outage protection)
What are the advantages?
There are many advantages to using parametric products. The major areas are detailed below.
- Speed of payment – Most parametric underwriters agree to pay claims within 30 days, with some payments made within 24 hours. This is made possible by the trigger being independently verifiable and the loss payment agreed in advance.
- Non-damage business interruption cover – This is an area where the traditional insurance market is notoriously wary and the availability of cover inconsistent. With a parametric product, however, there is no need to demonstrate damage. As long as the trigger conditions occur, the loss will be paid, irrespective.
- Tailored coverage – The objective trigger parameters are based on measurable events meaning the protection can be designed to respond to the specific needs of the client and risk location.
- Consistent pricing - Due to the objective and statistical basis on which premium ratings are calculated, the cost of the insurance is resultant on previously occurred events. In this respect, market conditions are aligned with the frequency and severity of events the insured wishes to insure against as opposed to the vagaries of the hard and soft market cycles of traditional insurance.
- Risk transfer alternatives – Contractors are normally comfortable with pricing and bearing weather risk in more benign territories such as the UK, but parametric insurance provides an alternative risk transfer option for owners or employers.
What is the process for determining a payment?
Typical parametric insurances are centred on a defined insured location, and are structured to pay out different percentages of an agreed limit depending on the severity of the event.
For example, a policy might be structured to pay out 50%, 75% or 100% of a chosen limit depending on the severity of a flood, defined by river water height above ordinary datum, happening at a prescribed location. The location is typically a point where there is a monitoring station and can be specified with longitude-latitude geographical coordinates.
The process for payment is typically as follows:
- Catastrophic event occurs
- Third party verifies intensity
- Payment is issued in as little as 30 days
- Insured must confirm loss is greater that parametric payment within one year. This is normally by way of a sworn statement and is intended to avoid unjust enrichment of the insured.
How has the use of parametric products developed in the hardening market?
Programme restructuring – for natural catastrophe exposed risks, insurance programmes are being restructured to move traditional insurance placements to a higher attachment point, creating a higher self-insured retention for the client. This lower level of risk is then managed through parametric insurance, providing a more cost effective solution with a quicker payment mechanism.
Non-damage risks – clients who are likely to suffer losses arising from meteorological conditions, irrespective of damage, are utilising parametric solutions. For example, a business that relies on benign wind speeds to operate safely cannot wait for damage to occur in order to suffer a loss. Substantial demobilisation and remobilisation costs accompany loss of trading profit when adverse conditions are forecast, whereas these would only cause physical damage if the insured was reckless enough to heed the warnings.
Basis risk – one of the longstanding issues with parametric insurance is basis risk. This concept recognises that measurement of the trigger condition may not be possible at the risk location, and instead perhaps at the nearest weather station. This creates the risk that whilst an insured suffers a loss, the conditions at the measuring station are less severe, failing to trigger the parametric policy. Happily, technology is creating solutions for this problem; more and more businesses are developing intelligent monitoring technology, be that for multiple triggers such as wind and rainfall, or single triggers such as water levels. These advances allow parametric insurances to be tailored to your exact risk location.
If you are interested in parametric insurances and how they could be used to enhance your construction project, please get in touch.