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By · August 16, 2022
6 minute read

Parametric insurance: a revolution for the SME insurance industry

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Parametric insurance is a new way of looking at providing cover. Mike Batey, director at MB Executive Ltd, looks at how parametrics could be a saving grace for small businesses looking for SME insurance should another pandemic occur.

Mike Batey, Director at MB Executive Ltd
Mike Batey, Director at MB Executive Ltd

When parametric insurance comes to mind, there is a tendency to make an immediate association with property catastrophe risk caused by climactic events. Moreover, we might also tend to think of parametric insurance users as being conglomerate-type businesses.

This perception, as of now, is mostly justified, since this is the market segment where the lion’s share of parametric insurance underwriters operate. However, the underlying principles of these index-based insurance products have potentially boundless application across the spectra of commercial risk and corporate size, from multi-national to SME.

The baseline for parametric insurance is the ‘trigger event’ and the extent to which that is identifiable and measurable, preferably by a trusted source that is independent of the insurer and the insured. We are now in a world where access to data with the granularity and reliability required to form a reliable index point is well and truly upon us.

Not only that, but the digital technology available to access, analyze and verify that data is developing at an unprecedented rate through the likes of data analytics, artificial intelligence, Internet of Things (IoT), satellites, blockchain technology, and smart contracts. Little wonder, then, that the global insurance industry is working hard to democratize parametric insurance solutions away from Big Catastrophe/Big Corporation target clients towards the lower-value, higher-volume end of the commercial market.

Parametric insurance is the key to cyber risk

Parametric insurance solutions are already emerging, or in development, for broader commercial applications in several key risk areas, one of which is cyber insurance. This has often proven a tricky field for underwriters of traditional indemnity-based insurance, not least because of a lack of in-depth knowledge about cyber risks and their unpredictable nature.

Cyber risk comes in several forms, of course, but if we take the example of business interruption risk due to outages and resultant downtime of business-critical systems, we begin to see how parametric insurance can play an increasingly important role. With reliable data sources on outages being both widespread and reliable these days, trigger points are clearly identifiable for index-driven, fixed pay-out products.

Other areas grabbing the attention of product innovators are terrorism and pandemic risks. If, as is widely expected, exclusions for these risks within indemnity-based policies are only going to tighten, parametric insurance may well provide welcome relief for commercial customers. We are also seeing the emergence of products that provide a commercial hedging mechanism, for example, fixed pay-out policies in the event of an adverse surge in a basket of commodity indices.

Supply and distribution chain disruption, event cancellation, and commercial travel are all risk areas that are in various stages of discussion or development in relation to parametric insurance. All of these have been brought into high relief as the world grapples with emerging from the pandemic and the fall-out from the situation in Ukraine.

Using parametric insurance to manage risk

While the range of potential parametric insurance risk coverage options is undoubtedly appealing to the SME commercial market, the nature of the proposition is too, with swift and no-quibble claims being high on the list of attractive features. As the broader application of solutions across the commercial spectrum matures, you would expect to see insurers being able to translate the fixed nature of their liability and ease of claims management into more keenly priced products.

A potential by-product of this type of insurance is the encouragement of improved risk management and prevention within the business itself. While the fixed pay-out nature of parametric insurance has obvious appeal there is always the danger that it won’t cover the actual cost of loss in the same way that a traditional insurance policy might.

One way that this can be mitigated is through improved enterprise risk management procedures and controls, even to the extent that the fixed pay-out might exceed the actual loss incurred. The example above of corporate cyber risk is perhaps a poignant one in this respect.

A restoration of trust

Another positive consequence could be the restoration of trust between the commercial policyholder and the insurance industry. The feeling that insurers will seek to wriggle out of claims through the policy conditions and exclusions of mainstream products is still highly prevalent. Yet, parametric insurance policies, by their very nature, do away with that fear.

While parametric insurance is clearly an exciting and real opportunity for all commercial enterprises in the future, none of the above serves to suggest that there will, over time, be a paradigm shift away from traditional insurance products. More likely is that one will complement the other.

For example, an innovative parametric insurance solution may be used to cover risks that traditional indemnity policies can’t, or where exclusions become too restrictive. Similarly, a fixed pay-out policy may be used in conjunction with an indemnity policy to mitigate the cash flow consequences of a high policy deductible. The result may well be that businesses can apply a bespoke blend of parametric insurance and traditional coverage to tailor an insurance program more specifically to their needs. This has mostly been the luxury of large corporations to date, for example through captive insurance programs, but we could see a similar tailored approach cascading down to the SME market.

Clearly the availability of reliable and measurable data will be at the core of any parametric insurance revolution into the wider commercial space. Arguably, the higher-volume, lower-value nature of the market, compared with catastrophe-driven parametric insurance, will demand increasingly sophisticated mechanisms for gathering and analyzing the data. Insurers will need to step up to this digital challenge to succeed.

To find out more about how the FintechOS platform empowers you to manage the extensive data you need to create parametric insurance policies, book a demo.

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