As modeling accuracy improves, parametrics should take off but regulatory support will be needed.

I recently had the opportunity to speak on a panel at the Wharton Business School's conference on "The Role of Insurance on Coastal Adaptation." My panel focused on the use of insurance to meet the needs of low-income families. We explored solutions to help with the adaptation and mitigation of climate change risks for low income families through insurance solutions. I focused particularly on parametric insurance and the great potential it holds.

Broadly speaking, parametric insurance pays a fixed amount to the buyer of the protection based upon the magnitude of an event, as opposed to the magnitude of the losses, once a predetermined threshold is triggered. This type of insurance is based upon a modeled forecast of loss to the policyholder and results in no (or very little) loss adjusting, which can be critical to those most in need of immediate assistance particularly after natural disasters.

The benefits of parametric insurance to both the insureds and insurers are numerous. For the insureds, speed, certainty of amount of payout, and the resulting ability to plan ahead ensure more rapid relief when disaster strikes. For the insurers, parametric insurance can lead to cost savings for claims adjustment and reduced claims fraud. It can also incentivize insureds to minimize loss, as payouts on the parametric insurance are not affected by total loss.

Technological developments yielding better data as well as improved analytics and modeling offer opportunities for the development and launch of parametric insurance products to meet the needs of a wider range of insureds including low-income families.

However, regulatory issues prevent most US consumers from benefiting from a robust offering of parametric insurance products. Most US state insurance laws and regulations are understood to require the indemnity principle—that insurance must indemnify the insured for an actual loss. This runs counter to the benefits of parametric insurance, especially fast claims payment without a lengthy and expensive claim adjustment process to determine the specific loss suffered by the insured. Insurance regulators who want to foster and support the development of much needed insurance products for their states, including to help low-income families cope with climate change risks, will need to provide guidance to support the growth of parametric insurance products as being consistent with insurance laws and regulations. However, in some states changes to the insurance laws or regulations might be necessary.

Until then, hybrid models that include parametric and indemnity elements can fill the need. Hybrid insurance products can have a parametric trigger that allows for immediate emergency funding to be released to a policyholder combined with a normal indemnity function that tops up any additional loss after claims adjustment. This innovative strategy could hold the key to providing immediate financial relief to those most affected by climate related disasters.

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