The main difference between traditional risk transfer and parametric risk transfer is how the pay-out is determined. With parametric risk transfer, an index is involved e.g. for wind speed if the policy covers hurricanes. The policy will state which windspeed conditions will trigger a pay-out. Only if the stated wind speeds are hit will a pay-out be triggered – there are no loss-adjustments involved.

The main advantages of parametric coverage are:

• transparency of cover;
• fast pay-out;
• coverage of some traditionally uninsurable risks;
• avoidance of adverse risk selection;
• no moral hazards;
• and instant emergency cash can be used to cover immediate expenses (non-physical).

However, there are a number of disadvantages also. These include:

• basis risk (risk that the pay-out may be less than actual loss incurred);
• and the need for objective and consistent, accurately measured data.

To place a parametric risk transfer successfully and sustainably, a number of prerequisites need to be met. The main prerequisite is having suitable data sets available about the peril to create the index. A well-defined index is critical to the sustainability of any parametric product: to minimise the base risk; and establish reliability and transparency.

So… is parametric risk transfer the right solution?

Parametrics can be suitable if:

• speed of and certainty around payment are crucial;
• more flexibility in the use of the payout amount is desired;
• the to-be-covered risk can be represented well by an index;
• basis risk can be managed adequately / loss adjustment is not practical and inefficient;
• and/or the client is already a buyer of traditional insurance.

However, parametric risk transfer may not be attractive if:

• it is difficult to establish correlation between the losses and the (data underlying the) index;
• index and payout structure are untransparent, complicated, and/or not tailored to client’s needs;
• and/or potential buyers have little experience with insurance.