05 July 2022

Digitization in the insurance industry: Parametric insurance

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  • Legal
  • Banking / Insurance

Digital technologies and innovations such as artificial intelligence (AI), the Internet of Things (IoT), distributed ledger technologies (DLT), smart contracts and data mining (DM) are leading to a fundamental rethink of the entire value chain in the insurance industry.

Features of parametric insurance

In the area of product development/underwriting/loss management, so-called parametric insurance enables interesting innovations. Parametric structures have been used in connection with catastrophe risks in reinsurance for some time (derivative insurance products) but in the wake of digitalization, they are experiencing increased attention in the primary insurance business as well.

The relevant features of a parametric insurance are:

  • The insured peril includes a predefined measure based on a specific parameter or independent/objective index (e.g., earthquake strength, wind strength, flight delay duration, water level, energy production volatility for renewables such as wind or solar strength, grid outages, etc.)

  • The insured event occurs when the measure is exceeded or not reached ("triggering event")

  • The insurance benefit is a lump-sum and independent of the actual damage suffered.

Advantages and disadvantages of parametric insurance

What insureds find attractive about parametric insurance is its transparency and efficiency. The entitlement to the insurance benefit as well as the insurance benefit itself are clearly defined, there are no claims investigations and, in principle, there should be no coverage disputes. For the insurer, claims management is efficient, simple, and inexpensive, and the problem of asymmetric information between insurers and insureds is reduced.

Using smart contract technology, the efficiency of parametric insurance may be increased even further, as the parameters or data of an independent/objective index can be easily fed into an autonomous processing infrastructure via a so-called "Oracle". The requisite data can then be generated directly and fully automatically via corresponding sensors in IoT applications (e.g. humidity, heat, technical system failure, etc.). When a triggering event occurs, the transfer of the insurance benefit can be initiated by the smart contract within seconds.

The difficulty of parametric insurance is in determining an appropriate insurance benefit for exceeding or falling short of the desired measure. Specifically, there is a risk of an insurance benefit that is too high or too low (basis risk, "near miss"). Therefore, in many cases, parametric insurance is unlikely to be a (complete) substitute for insurance based on a specific loss.

Depending on the jurisdiction, it could be problematic if the insurance benefit is higher than the actual loss incurred as a result of lump-sum damage or if a pecuniary loss suffered is not a prerequisite for an insurance benefit (fixed benefit insurance).

Fixed-benefit or indemnity insurance

In Switzerland, the parties can conclude a fixed benefit insurance policy (Summenversicherung) or an indemnity insurance policy (Schadenversicherung) not only in the case of individual insurance (life, health, and accident insurance), but in the entire area of private insurance. This was already considered permissible prior to the partial revision of the Insurance Contracts Act (ICA) and further clarified by the deletion of the previous provisions on the insurance and replacement value as part of the partial revision of the ICA. The purpose of indemnity insurance is to compensate, in whole or in part, a loss that occurs as a result of the insured event, whereby the loss can also be determined on a lump-sum basis. Fixed benefit insurance, on the other hand, does not have a compensatory character; it is a benefit defined at the conclusion of the contract and is owed regardless of the actual amount of the economic loss. Of great practical relevance is the distinction regarding the so-called right of accumulation. Benefits of a fixed benefit insurance policy may be accumulated, while benefits of an indemnity insurance policy must be offset against other benefits. According to the case law of the Federal Supreme Court, a fixed benefit insurance policy exists if the parties have made the agreed benefit of the insured solely dependent on the occurrence of the insured event, without regard to its financial consequences and the existence of a possible loss. On the other hand, an indemnity insurance policy exists if the actual loss of assets is an independent condition for the entitlement to benefits.

According to the will of the parties, a parametric insurance policy can be designed as indemnity insurance as well as fixed benefit insurance. Thus, the will of the contracting parties becomes the defining measure. Of course, the coordination with social security and indemnity institutions does not depend on the will of the contracting parties. The design of the parametric insurance policy as a fixed-benefit insurance allows for more efficient claims processing since coordination with other insurers is not necessary. According to the revised ICA, the insurer must inform the insured in any case whether the insurance coverage is a fixed benefit or an indemnity insurance.

Demarcation from other areas

Questions arise in connection with parametric sum insurance regarding the demarcation of the insurance contract from a derivative on the one hand and from a gambling transaction on the other. An insurance transaction should always be assumed as long as there is an insurance activity subject to supervision by at least one party, i.e. when a party systematically concludes independent insurance contracts in which risk is transferred against a premium.