Parametric insurance

Answer

The construction industry is particularly vulnerable to the effects of the Earth’s changing climate. Large-scale projects take a long time and cost substantial sums to finish, remaining at the mercy of the elements regarding both conditions for construction and supply chains. Extreme weather events, from hurricanes and floods to lightning and fires, can wreak havoc on construction sites, causing damage and delays that practical precautions may not fully eliminate. As a result, insurance is a fundamental tool for construction companies, allowing them to share their risks with insurers. The traditional model for insurance involves the linking of actual losses caused by, for instance, a weather event with a potential indemnity payment from the insurer, subject to the terms of the policy. Such policies include construction all-risk insurance, which covers buildings during construction, temporary works and machinery, for example, along with professional indemnity insurance, which covers certain third-party liabilities. Over the past few years, parametric insurance has emerged as a further option in this context for some developers, potentially complementing traditional insurance policies.

What’s parametric insurance?

In simple terms, an insurance policy is a promise by an insurer to pay money up to a particular amount if specifically defined losses or events occur, subject to policy terms such as exclusions and excesses. The promise is in exchange for a regular or upfront payment from the insured known as a ‘premium’. Therefore, the insured will potentially be entitled to an indemnity payment, which is usually above a particular excess, up to a specified limit. The determination of the amount to be paid within those boundaries is done via loss adjustment, which involves investigating the losses/event to be covered by an indemnity payment.

A parametric insurance policy isn’t linked to actual loss suffered by the insured, but rather to specified parameters. When the parameter is met, it acts as a trigger for the policy. In the context of weather events (perhaps made more frequent or severe by climate change), the parameters in question can be, for example, wind reaching a particular speed or rainfall reaching a particular level in a specified area. Naturally, the parameter in question needs to relate to the actual risks that could arise; for example, a rainfall parameter may be appropriate where precipitation is likely to affect the progress of the construction works.

Complementary potential

The characteristics of parametric insurance may give it the potential to complement other insurance policies, thus improving resilience against climate change-caused weather events.

Two key linked advantages of parametric insurance can be the speed of payment and its assurance. Once the parameter specified in the policy is met, subject to terms, the processing of the claim should be relatively straightforward as the main condition for payment has occurred. For instance, if local flood water levels exceed a specified threshold, then regardless of the extent of the impact on the insured’s construction site, there should be no impediment to payment with minimal scope for delay.

This can be valuable to developers, as they’d then have the potential to quickly inject cash into the business, helping to cope with a crisis. By comparison, traditional insurance policies are likely to take longer to pay out due to the need to assess specific losses suffered. In the context of climate change, parametric insurance is also suited to weather-related events because the potential weather-linked event can’t be influenced by the insured. The use of third-party data on the point reduces the risk of fraud.

However, multiple factors indicate that parametric insurance is more likely to complement traditional products rather than replace them in the building of resilience against climate change. Parametric insurance can be expensive: the policy is meant to pay-out subject to terms whenever a parameter is met, the high premium naturally reflecting the greater exposure for the insurance provider. Being a relatively new product for insurers, the costs of marketing parametric insurance can also be significantly higher than those of traditional insurance, driving up premiums. Naturally, there can also be savings in parametric insurance such as the removal of the need to pay a loss adjuster if cover is triggered. Overall, however, traditional insurance may remain more cost-effective, and in many instances better suited, in some respects.

There’s also the additional (reciprocal) risk that if the trigger parameter isn’t carefully drafted, losses could occur without the policy being triggered (or vice versa). Traditional insurance responds to actual loss, thereby reducing uncertainty for both policyholders and insurers.

Significantly, different jurisdictions view parametric insurance differently and specifically whether parametric insurance is able to satisfy the indemnity principle. This means that while parametric insurance has been accepted as insurance in the UK, with its status having been previously considered by the Law Commission, in many jurisdictions the status of parametric insurance as insurance isn’t so clear. A key reason is the lack of a direct connection to loss, which creates the chance that an insurer’s pay-out will go beyond indemnifying a policyholder if it’s bigger than the actual loss suffered. Traditionally insurance policies are meant to indemnify and not enrich. As a result, some jurisdictions will wish to see payment on a parametric insurance policy conditional upon at least some loss being demonstrated.

Conclusion

Parametric insurance may offer developers a relatively swift and predictable injection of cash in a crisis, but this type of policy may be most cost-effective and function at its best when supplementing traditional insurance. It can be observed that the use of proxy parameters in policies offers new angles to cover and brings complementary advantages to policyholders, in part by bypassing the traditional loss-adjustment process. The area will be intriguing to watch with regards to how the cooperation between parametric and traditional insurance develops in practice and whether the acceptance of parametric insurance as insurance spreads internationally.

Tad Adamek is a trainee solicitor at Clyde & Co LLP.