Contrary to the reimbursement method of standard commercial policies, parametric insurance is a form of coverage that offers protection based on a predetermined, measurable characteristic tied to a covered event.
Under such coverage, the amount in which a policyholder is compensated isn’t decided by the exact cost of damages sustained, but rather by the calculated intensity of the covered event itself. For instance, if a hurricane caused damage to a commercial property, a parametric policy might reimburse a set dollar amount linked to the storm’s wind speeds.
Parametric insurance can be a particularly beneficial form of coverage to have in the scope of large-scale natural disasters, especially when not all associated losses entail physical damages. Yet, there are some additional aspects of this coverage offering to consider. Review the following guidance to gain a better understanding of parametric insurance.
How Parametric Insurance Works
To fully comprehend how a parametric policy works, it’s important to first take note of how standard commercial insurance coverage operates. Following a covered event, traditional policies typically provide reimbursement for the exact cost of the resulting damages.
For example, if a fire destroyed a business’s building, the business’s commercial property policy would likely compensate the precise amount of funds needed to restore the building. This amount is often determined by a loss adjuster, who conducts a careful assessment to accurately establish the overall expenses stemming from an event.
Parametric insurance, on the other hand, does not focus on the physical damages incurred from a covered event. Instead, reimbursement is based on the severity of the actual event. Potential indicators of a covered event’s intensity—also known as triggers—must be independently verifiable, relatively simple to measure following the event and adequately representative of potential losses that could arise from such a disaster.
Some covered events only need one trigger to activate policy reimbursement, while others require multiple. Common triggers include floodwater height, hurricane wind speed and earthquake magnitude. As such, a commercial property’s parametric policy could be set up to provide a set payout amount in the event that the property experiences an earthquake above a magnitude of 5.1 on the Richter scale.
Further, parametric coverage can also offer increasing payouts as a covered event intensifies. In this scenario, the set payout amount for a magnitude 7.5 earthquake could be greater than that of a magnitude 5.5 earthquake—such as 75% of the policy limit versus 50% of the policy limit, respectively.
Benefits of Parametric Insurance
Recent years have seen a sharp rise in both the frequency and severity of natural disasters across the country. Between raging wildfires on the West Coast, severe tornadoes across the Midwest and devastating hurricanes throughout much of the Southeastern states, more and more businesses are encountering the costly consequences of large-scale natural disasters.
What’s worse, climate experts predict that these disasters will only continue to increase in the years to come—making them an ongoing concern for many business owners. With this in mind, parametric insurance can be an advantageous form of coverage for any business located in an area prone to specific weather events.
In addition, parametric insurance can also offer the following key benefits:
- Timely payouts—Because traditional policies cover the exact cost of loss from an event, policyholders won’t receive their payout until the loss adjuster has fully assessed the damages and determined an accurate reimbursement amount with the insurance carrier—which can be a long process. However, since parametric policies already have predetermined reimbursement amounts in place based on event severity, such policyholders are more likely to receive fast payouts after a covered event.
- Increased flexibility and customization—While standard policies don’t always provide much room for customization, parametric coverage is far more flexible. That is, the main features of this insurance—namely, the trigger details and set payout structures—can be specifically designed to meet the unique needs of the policyholder.
- Coverage possibilities—Lastly, the payout method utilized within parametric policies often allows for expanded coverage capabilities. Instead of the reimbursement amount being automatically designated to a specific expense (e.g., the cost of repairing the property’s roof), policyholders can use their own judgment to determine how to make the most use of their payout. This freedom permits policyholders to spend their reimbursement funds on loss elements that aren’t necessarily physical or outwardly evident (e.g., business interruption concerns).
Additional Considerations
Despite the benefits of parametric insurance, there are some additional coverage considerations to keep in mind.
First, parametric policies are always accompanied by some degree of basis risk. This refers to the possibility that the preestablished reimbursement amounts for different covered events may not end up fully covering the total cost of damages that the policyholder incurs. While basis risk can be present in any commercial policy, it is especially common within parametric policies that lack thoughtful trigger details and payout structures. To minimize this concern, it’s critical to consult your insurance carrier and trusted broker to ensure you fully understand your policy’s structure and possess adequate coverage for your particular exposures.
Second, parametric insurance can sometimes be more expensive than traditional coverage. Although such contrasting policy conditions make it complicated to compare prices between standard and parametric insurance, the latter form of coverage can be accompanied by elevated premium costs when the payout structure allows for a wide range of protection.
Finally, most parametric policies contain what’s known as a proof-of-loss requirement. This means that even though the reimbursement amount will be determined by the severity of the covered event, the policyholder must still submit some form of evidence that proves they experienced a loss from the event in order to receive a payout. Such a requirement removes the risk of policyholders unaffected by an event fraudulently receiving reimbursement. To ensure the payout process runs smoothly and efficiently, it’s crucial to have a plan in place for providing proof of a loss after a covered event (e.g., taking pictures of damages and saving receipts).
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This Coverage Insights is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel or an insurance professional for appropriate advice. © 2021 Zywave, Inc. All rights reserved.