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By: K. James Sullivan, CALFEE, HALTER & GRISWOLD LLP
This article addresses the topic of parametric insurance, a type of insurance that does not indemnify the pure loss, but ex ante agrees to make a payment upon the occurrence of a triggering event.
IT DESCRIBES PARAMETRIC INSURANCE, OUTLINES ITS origins and the operation of claims payment and trigger events, provides details about the coverage both in the United States and around the world, and explains the benefits and challenges of parametric insurance.
Parametric insurance is a new class of evolving index-based insurance products. An index-based insurance policy pays out claims based on a predetermined index, such as rainfall levels or wind speeds. It is called parametric insurance because policy parameters are set around a specific set of metrics. Unlike traditional insurance, parametric insurance does not indemnify the insureds against their actual losses. In fact, actual losses are nearly irrelevant to parametric insurance. Instead, parametric insurance protects insureds from the probability of a predefined event happening. For example, in the event of a hurricane, traditional insurance would pay an insured the value of the insured’s covered and actual losses, but a parametric insurance policy would pay the claim based on whether the wind reached a certain speed, regardless of actual damages. Parametric insurance products exist for a wide variety of risks, and new products are constantly being developed to meet the needs of insureds, but typically, the risks covered by parametric insurance are those that have historically been difficult to insure—rare events that cause extreme losses.1
The new class of evolving index-based insurance products known as parametric insurance is coverage tailored to the insured’s specific risks. Parametric insurers currently operate under the same regulatory framework as traditional insurance insurers. While traditional insurance plans are most commonly annual, parametric insurance products are often multiyear plans of up to five years. Alternatively, some parametric plans are seasonal, operating to insure risks only during the hurricane season or drought cycle, for instance. Most parametric insurance products are written for commercial clients or governmental units and are bespoke contracts. Rather than selling a standard policy, most insurers work directly with the insured to develop a parametric insurance plan that is tailored to the specific risks of the insured. These are high-value, high-cost plans that often pay out millions of dollars. Parametric insurance is not meant to be the sole insurance policy for an insured; instead, it functions as a supplement to traditional insurance that increases liquidity immediately after a foreseeable and reasonably likely loss.
Parametric products have existed in some form or another since the late 1990s and evolved from the practice of issuing catastrophe bonds, which are colloquially known as cat bonds. Cat bonds are risk-linked securities that transfer a specified set of risks from one party to investors and were developed after Hurricane Andrew and the Northridge earthquake led to the insolvency of several insurers. In many ways, cat bonds are like parametric insurance for insurers because they transfer the risk of catastrophic, high-damage natural disasters from the insurer to investors and are issued to complement traditional reinsurance. While some cat bonds pay the issuer based on actual losses, many pay out based on parametric triggers.
The evolution of parametric insurance from cat bonds is not well documented, perhaps in part because parametric policies are usually bespoke contracts created for individual commercial clients. One of the earliest documented instances of parametric insurance was not actually an insurance policy at all, but a full-fledged cat bond. It was issued to protect Disneyland Tokyo from earthquakes in April of 1999 and promised a $100 million payout if triggered. This bond utilized a parametric set of triggers where the park was enveloped by three concentric circles which were each assigned a trigger magnitude: 6.5 or more on the JMA scale in the inner circle, 7.1 in the middle circle, and 7.6 in the outer ring. The further away the earthquake epicenter was, the stronger the earthquake had to be to trigger a payout. (This framework where there are pre-agreed areas protected from given catastrophes is often referred to as cat-in-the-box).
The Caribbean Catastrophe Risk Insurance Facility Segregated Portfolio Company (CCRIF) was developed eight years later as the first insurance instrument to successfully utilize parametric policies backed by both traditional and capital markets. Moreover, CCRIF was also the first regional risk-pooling fund to issue parametric insurance. CCRIF is organized as a nonprofit mutual insurance company, and originally it served the governments of 16 counties in the Caribbean. It was developed as a response to the damage caused by Hurricane Ivan, which devastated the region in 2004. The primary problem for the governments of these devasted countries was post-disaster liquidity—there was a gap between the exhaustion of emergency funds and the receipt of charitable donations, leaving governments struggling to provide essential services or begin the recovery process. The Caribbean Community (CARICOM) resolved to find a solution and petitioned the World Bank to assist them in designing and implementing a cost-effective means to transfer catastrophic risk. The primary goal of the program was to sustainably provide quick, short-term liquidity after natural disasters at a price that these governments could afford.
CCRIF utilizes parametric equations and data supplied by the National Hurricane Center and U.S. Geological Survey to determine coverage and calculate payments. The countries are divided into zones, and each zone is assigned its own parametric equation that gives weight to the zone’s population size and the amount of governmental infrastructure. The weight assigned to the zone corresponds to a specified proportion of the government’s risk exposure. Generating the government’s gross loss (and its payment) merely consists of plugging in the data, such as wind speeds or earthquake magnitude, to the relevant zone’s parametric equation. The aggregate of the zones’ outputs comprises the ultimate payment, which can then be made immediately with no need to prove losses. CCRIF has been a remarkable success, making 54 payments totaling $245 million between its inception and 2022. The program expanded over the years to now cover 23 countries, including three Central American countries. It offers coverage for earthquakes, tropical cyclones, and excessive rainfall as well as special policies specifically designed to protect fisheries and electric utilities in the event of extreme weather. In the years since CCRIF was launched, there has been an explosion in the use of parametric insurance products.
Claims payments are based on the magnitude of the specified trigger event, rather than the magnitude of the losses caused by the event. Payment values are calculated using predetermined parametric equations, a type of equation that employs an independent variable called a parameter in which dependent variables are defined as continuous functions of the parameter and are not dependent on another existing variable. This equation ties the payments to the index. As an example of how this equation functions, a policy might pay a certain amount per millimeter of cumulative rainfall above a certain threshold. Because parametric insurance is divorced from the actual losses of the insured, it may look like gambling in some respects, with premium payments serving as the equivalent of a bet that a certain event will happen. To differentiate parametric insurance from gambling, the United States requires that insureds show proof of some actual loss, though the value or magnitude of that loss is not relevant. The burden to prove actual loss is light though, and U.S. regulators have accepted minimal proof such as drone footage or text messages from customers describing the losses.
For a parametric insurance policy to operate most effectively, the trigger event should be easily defined and verifiable by a reputable government organization. For instance, windspeeds make a good trigger event because insurers and insureds can easily and clearly define the metrics that will trigger a claim, and wind speeds can be reliably verified through the National Weather Service. The trigger event should also be directly related to the risk that the buyer seeks to protect against. For instance, a business near the coast might protect itself from hurricane damage by buying a parametric insurance product with high windspeeds as the trigger event while a farmer seeking protection from crop failure would want a policy with low levels of rainfall as the trigger event. The potential discrepancy between actual losses and claim payments is mitigated because insurers carefully design the trigger parameters so that if a trigger is met, the likelihood of actual losses is high.
The most efficient parametric insurance products use triggers that are tied to the location of the insured assets. This helps insureds and insurers establish trigger parameters that are consistent with the likelihood of actual losses. Some older models of parametric insurance differ though. With the cat-in-the-box or circle method, the policy is triggered if the eye of a named windstorm passes through a predetermined circle (or other geometry) around the insured asset and exceeds the intensity defined in the policy. Cat-in-the-box policies are high-risk for the insureds because they only consider the path of the storm and intensity at the center, leaving intact the risk from high windspeeds at the fringe of the storm. Another trigger method is the fixed anemometer policy, which pays claims based on whether a named windstorm exceeding certain speed passes by the anemometer nearest to the insured’s asset. This method is also a high basis risk because anemometer stations are often miles away from the insured’s assets. Despite their shortcomings, cat-in-the-box policies are still the most popular parametric insurance product to date.
So long as the triggers are objective, independently verifiable, transparent, and consistent, the only limit as to what may classify as a trigger is the imagination of the insurers and their insureds. Parametric insurance products have included triggers such as power outages, crop yields, and other intangible market factors. Some triggers may even be entirely peril-agnostic, such as a policy for a hotel that pays out whenever bookings or revenue drop below a certain threshold.
Since CCRIF showed the world just how efficiently parametric insurance can work, there has been an explosion in the amount and variety of parametric products offered globally. The majority of these new insurance products cover the risk of various natural disasters. In Japan, Swiss Re offers a parametric insurance product that protects corporations and public organizations from tsunamis. Started in 2011 as a response to the $210 billion in damages caused by the Tohoku tsunami, the policies pay out between $30 and $100 million within 40 days. The trigger event is the height of the waves. In addition, Swiss Re also developed a typhoon warning policy for Hong Kong businesses that is designed to mitigate business interruption risk by paying claims in the event of a typhoon warning of eight or higher. Note that the policy is triggered by the warning of a typhoon, not the typhoon itself. A sovereign risk pool similar to CCRIF, the Pacific Catastrophic Risk Insurance Company was launched in 2013 and provides Pacific Island countries with parametric insurance products covering tropical cyclones, earthquakes, and tsunamis.
Parametric insurance is not limited to natural disasters though. One particularly useful application is crop insurance. After French vineyards suffered significant losses in 2017 due to a severe drop in temperature, Mateo Protect began offering a parametric insurance product for vineyards that is triggered by low temperatures during the growing season. In Africa, World Food Programme’s R4 Rural Resilience Initiative pays farmers based on a rainfall index. Parametric insurance products have also been developed for event organizers and retailers who might lose revenue in the event of rain or bad weather. Pandemic insurance was designed to help fund developing countries after the 2014 Ebola epidemic in West Africa. Once a covered virus reached a predetermined pandemic level, the claims would be paid.
Experimentation with parametric products has led to some novel applications as well. In 2018, the Mexican state Quintana Roo, the Nature Conservatory, and the reinsurance company Swiss Re partnered to develop a parametric insurance plan to protect the Mesoamerican Reef. This was the first parametric policy to be taken out on a natural resource. Wind speeds near the reef serve as the trigger event, and when the policy is triggered, an automatic payment is made to the local government so that it can begin repair and restoration of the reef right away.
Adoption of parametric policy structures has been slow in the United States. In 2018, PathogenRX was offered by Marsh as a parametric pandemic insurance product, but not a single policy was sold. After the economic devastation caused by the COVID-19 pandemic, business owners were distraught to learn that traditional insurance policies did not cover business interruption losses caused by pandemics. Shortly thereafter, the popularity of parametric pandemic policies exploded. Primarily, the trigger for these policies is the declaration of a health crisis by a government agency. Other potential triggers include number of infections, hospitalizations, or deaths within a given locale.
Other insurance products offered in the United States cover a variety of risks, including windstorms, earthquakes, hail, too much rain, not enough rain, and crop failure. Parametric insurance is also popular in the construction industry where poor weather can delay projects. Though parametric insurance has not traditionally been a consumer product, the Innovation Workstream of the National Association of Insurance Commissioner Climate and Resiliency (Ex) Task Force has been conducting a study on the feasibility of using parametric insurance as a stop gap for low-income households, which may struggle under traditional plans offering high deductibles or low coverage limits. Additionally, there are a few insurers who do offer small-value parametric policies to consumers. In California, consumers can purchase up to $10,000 in parametric earthquake coverage, and in Florida and Hawaii, consumers can purchase parametric insurance products designed to help cover deductibles and excluded damages caused by hurricanes.
Parametric insurance is currently regulated in the same manner as traditional insurance. Most state and all federal codes and regulations make no explicit reference to parametric insurance. Only Tennessee mentions parametric insurance in its code, defining parametric insurance and stating that “any captive insurance company, except for a risk retention group, may provide parametric insurance policies, which are considered contracts of insurance for the purposes of this title.”2 However, several states have introduced bills related to parametric insurance, though none have passed. In 2017, Washington’s state legislature considered creating a task force to evaluate innovative and standard approaches to disaster relief, including parametric insurance. Likewise, California is considering implementing a study to evaluate, among other things, heat index-triggered parametric insurance as a solution to local heat risks. Hawaii has also been considering the feasibility of parametric insurance as a means to mitigate climate change through various failed bills introduced since 2015. Puerto Rico is the only state or territory that has adopted regulations designed to foster parametric insurance. Raincoat administers these microparametric policies that pay out $1,000 less than 15 days after windspeeds trigger the policy.
Federally, Congress considered S.B. 3072 in 2017,3 which recommended that the National Ocean Service assess whether parametric insurance has a role in proposals to protect coral reefs. Then in 2021, in the height of the COVID-19 pandemic, Congress considered the Pandemic Risk Insurance Act of 2021.4 This act would have created a parametric insurance facility, which is a nonassessable joint underwriting association providing parametric insurance for business interruptions caused by pandemics. Although much fanfare surrounded this concept, as of November 2022, it had not gained meaningful federal legislative traction.
In terms of case law, only one case involving parametric insurance has been documented in the United States. In Johnson v. Climate Corp.,5 plaintiffs alleged that the insurer sold a policy based on the data from the previous year and misrepresented the policy while defining the triggers in such a way so as to pay out less often. The court denied the defendant insurer’s motion to dismiss. Although the court’s denial of the motion to dismiss did not delve deeply into parametric insurance considerations, two noteworthy points were that the court found that factual inquiry was needed to discern whether the policy metrics were triggered, and the court indicated that bad faith claims can possibly be brought against parametric insurers much like bad faith claims exist in the traditional insurance context.
Without the need to assess actual losses, claim payments can be dispersed very quickly, increasing post-event liquidity, and allowing parties to make repairs immediately. This is especially helpful for business-interruption claims when wages need to be paid to employees. It also reduces the overhead for the insurance company by virtually eliminating the claims-handling process. As streamlined as the parametric claims-handling process already is, in the future, it could be completely automated using blockchain smart contracts. Because the trigger for any parametric claim is objective and verifiable by disinterested third parties, the likelihood of potential coverage disputes is significantly less than with traditional insurance policies. Indeed, there has been only one reported case related to a parametric insurance policy in the United States to date. Parametric insurance may also reduce moral hazard: the insureds have an incentive to minimize losses because their actual losses are not covered.
It also reduces the risk of both insurance fraud and bad faith claims processing because the events are large scale and independently verified. Because the claim payments are divorced from actual losses, insureds can use the proceeds to remediate damage that would not typically be covered by a traditional insurance policy, such as sublimited or excluded losses (beach erosion, landscaping, tennis courts, etc.), evacuation costs, or increased operating expenses. This makes parametric insurance a good supplement to traditional insurance.
Another benefit of parametric insurance is its bespoke nature. Each policy is aligned to the insureds’ own risk tolerance with a unique index and payout structure. For instance, a client with earthquake mitigation measures in place might only want to insure against earthquakes of a certain magnitude, knowing weaker earthquakes will not damage their buildings. Meanwhile, another client may not have any mitigation strategies in place and need coverage for even weaker earthquakes. On the other side of the coin, insurers can use large data sets to carefully design triggers so that claim payments better correlate with actual losses.
Of course, parametric insurance does pose its own unique challenges. With traditional insurance, the basis risk is the deductible and the possibility that the losses will either be excluded or exceed policy limits. With parametric insurance, the basis risk is higher because the insured may suffer losses from an event that fails to trigger the policy, especially with cat-in-the-box policies.
For instance, an insured’s roof might be damaged by winds even though the eye of the storm does not pass through the circle, or the winds never reach the trigger speed. Careful trigger design mitigates these risks by ensuring that the trigger relates to actual losses as much as is possible, but the onus for this is on insurers who have little incentive to design triggers to pay out more often.
There is also the possibility that parametric policies taken out by governments may increase moral hazard. While the policies do increase the incentive to take measures to mitigate losses, they decrease the incentive to prevent the type of events that trigger coverage. Governments protected by parametric policies may lose interest in disaster mitigation strategies that would reduce the likelihood that the policy is triggered, such as forest management techniques that reduce the incidence of forest fires or efforts to bolster natural buffer zones that reduce windspeed in the event of a hurricane. Finally, because all of the parametric policies currently being offered are bespoke, it may be more difficult for insureds to obtain information about policies and compare prices.
As the frequency and value of catastrophic losses continue to increase in the coming years and decades, coupled with the increasingly sophisticated data and modeling available to insurance markets, parametric insurance is expected to further mature and expand, becoming a key piece of many public and private entities’ risk management programs.
K. James Sullivan is a partner at Calfee, Halter & Griswold LLP. As leader of Calfee’s insurance recovery practice, James counsels corporate insurance policyholders on insurance coverage issues and litigates insurance coverage disputes. He also litigates and helps resolve clients’ general business disputes.
Mason Patrick, a 2023 JD candidate at The Ohio State University Moritz College of Law, contributed to this article.
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1. See Steven L. Schwarcz, Insuring the “Uninsurable”: Catastrophe Bonds, Pandemics, and Risk Securitization, 99 Wash. U. L. Rev. 853 (2021); Carolyn Kousky & Sarah E. Light, Insuring Nature, 69 Duke L.J. 323 (2019); and Hannah M. Petersen, Parametric Payouts and Environmental Conservation: How a Tech-Based Insurance Policy Could Pave the Way for Economically Viable Conservation Efforts, 20 N.C. J.L. & Tech. On. 75 (2018). 2. See Tenn. Code Ann. § 56-13-103(a)(10). 3. See 2017 Legis. Bill Hist. U.S. S.B. 3072, and Commerce, Justice, Science, and Related Agencies Appropriations Act, 2019, 115 S. 3072. 4. 117 H.R. 5823. 5. 2016 U.S. Dist. LEXIS 197940 (D. Neb. Nov. 22, 2016).