Parametric insurance: How it can benefit construction companies

By Andy Desmond ,

Marsh UK Industries - Construction Industry Leader

13/03/2023 · 2 minute read

Climate change is triggering more extreme weather events. How can the insurance industry help?

The transitioning insurance market has made it more expensive for construction companies to insure against natural catastrophe (“nat cat”) perils. The market saw increases in capital and capacity worldwide leading up to 2017, partly due to the lack of natural disasters for several years. However, since then, extreme weather events have had a disruptive effect across the insurance industry.

Many insurers have become more selective about what risks they underwrite, moderating capacity in regions that are prone to extreme weather events. As a result, nat cat premiums have increased, leading insurance buyers to consider alternative forms of cover, including parametric insurance.

What is parametric insurance?

Parametric insurance, a policy triggered by the movement of a parameter (or index), has existed for over 20 years. It is flexible and can cover many scenarios and has been used successfully in sectors such as energy and agriculture to protect against exposure to extreme weather. Another example would be in the film industry, when coverage has even been sought when a certain number of hours of sunlight to shoot outdoor scenes is required.

A parametric insurance solution is a contract designed to insure a policyholder against the occurrence of a specific event, with the payout limit defined by the magnitude of the event. Parametric insurance offers flexible coverage for difficult-to-model losses, as the risk parameters are adjusted prior to the event and payment is triggered immediately by the event and scale thereof, resulting in faster payouts. For policyholders, this type of insurance offers claims transparency, and for insurers, it offers more simplified underwriting with capped liabilities.

With a traditional insurance policy, a premium is paid in return for the promise to cover the actual loss incurred for an incident or named peril. Payment is made only after an actual loss assessment and damage investigation has been completed following a claim, with the goal to put the insured back in the position they were prior to the event.

Parametric case study

Windstorm exposure: Replacing traditional capacity to improve coverage

Wind Storm Parametric – Southern USA

Background

Our client operated an industrial plant in southern USA. They had sustained significant economic losses from a hurricane in 2017). However, their conventional nat cat insurance had not sufficiently compensated them, for two reasons:

Deductibles imposed by the insurance market were very high.
Much of the economic loss incurred was contingent business interruption and was not covered by their traditional policy.

Our goal was to replace the traditional coverage with a parametric policy, calibrated to ensure payout when losses occur after major hurricanes.

Solution

We designed a policy that would be triggered if a hurricane crossed a line segment drawn along the coastline in the region of the insured’s operations.

The selected line was about 150 miles long and would safely pick up the track of the 2017 hurricane.

Trigger

The trigger for the policy was Category 3 (110mph) or higher wind speed, with graduated payouts increasing with measured wind speed.

If the 2017 storm were to occur again (it was a Category 4 storm when it crossed the coastline) this policy would have generated a payout of tens of millions of dollars for the client.

Parametric insurance example:

Recently, a digital insurance intermediary launched a micro-insurance product to target underinsurance of nat cat and climate risks in the Caribbean. It monitors event wind speeds and the atmospheric pressure at the centre of a hurricane. If wind strengths reach pre-agreed limits, categorised as low, medium, high, very high or extreme, then a corresponding payment will be issued to the policy-holder. The platform fully automates distribution, claims processing and customer payouts within a maximum of 10 days following a hurricane, although it is often within 24 hours.

Because parametric insurance is an agreement to make a payment upon the occurrence of the triggering event, it is detached from an underlying physical asset or piece of infrastructure. It is also designed to indemnify without differentiating between the categories of costs incurred by the insured, which also makes claim payment faster and simpler.

A successful solution therefore pays the insured much more quickly than a traditional indemnity insurance, usually in days rather than months, and may in some instance compensate the insured for more of their true economic loss — the solution considers things like downstream impacts, increased costs, reputational effects, and contractual liability.

Parametric insurance for construction companies

While weather parametric insurance (nat cat or gradual weather) is most commonly thought to be of interest to construction firms, other forms are also available, such as cyber parametric insurance, which can operate on an index such as cloud provider downtime. As the construction industry becomes more digital and cloud-based, companies are becoming more interested in such cover.

Parametric coverage also recognises that contractors and owners face different economic risks from project delays. An owner may incur heavy revenue losses from operating profits that aren’t being realised. A contractor, on the other hand, can be impacted by high daily penalties when missing project deadlines. Payouts are simply based on indemnity and do not distinguish between the types of financial loss.

How parametric insurance can help with pandemics and terrorism

Innovative parametric solutions are being introduced to fill the gaps found in other types of coverage. This is sparking interest among potential insureds seeking solutions that expand capacity or protection not available in the conventional market.

For example, in the construction industry, instead of, or in addition to, taking out terrorism or pandemic cover, developers are considering footfall cover for shopping centres, so that if the footfall drops by a certain percentage outlined on the index, a payment is triggered. This could provide cover for gaps in pandemic and/or terrorism cover left by traditional insurance.

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