Hi, I'm Martijn, a technology enthusiast with a background in VC / growth equity investing at Fortino Capital, HPE Growth and Allianz X as well as operational experience at N26, Adyen, and Mondu. My articles explore emerging fintech trends in the European tech ecosystem. Today, I'm sharing an article about the parametric insurance space in Europe 🇪🇺
Insurance is an agreement or a legal contract represented by a policy between two parties namely, the policyholder and the insurer. The former receives financial protection of an asset (e.g., house) in the event of loss or damage from the insurer in exchange for a fee (i.e., premium payments). Hereby, insurance companies accept risk in exchange for periodic payments with the possibility of having to conduct a claim settlement. Insurers are willing to take the risk as they benefit from the pooling of risk of millions of customers. From the perspective of the insured, it is a form of hedging against the occurrence of an unexpected event. The figure below demonstrates the risk transfer principle.
Figure 1: Risk transfer principle
So what is parametric insurance? Parametric insurance (i.e., index based solutions) covers the insured depending on the probability of a predefined event occurring instead of covering the actual loss incurred. The end customers of parametric insurance include both ordinary consumers (e.g., homeowners in Florida that are subject to frequent floods) and commercial customers. It is part of the greater property and casualty (P&C) insurance family. Parametric insurance differs from traditional insurance with respect to the triggering of the event and pay-out scheme.
For event triggering, a specific value on a pre-defined parameter has to be met or exceeded. The index utilized has to be objective, transparent, and consistent. In addition, the index has to be measured with information provided by an independent provider. For example, in the context of earthquakes, the index used will be the magnitude scale of an earthquake with information provided by an agency such as the Euro-Mediterranean Seismological Centre (EMSC).
Concerning the pay-out scheme, once the magnitude of the natural disaster equates to or exceeds the pre-defined strength of the index, the payment is made within a short period of time (usually two to four weeks). In traditional insurance policies, the insured will be required to wait longer periods of time as the damage of the insured asset has to be analyzed and the claim processed. Therefore, the main pay-out difference stems from the fact that the claims adjustment policy is absent in parametric insurance.
It is important to note that for a business to be eligible for parametric insurance, the event has to be unexpected and the scenario can be modelled. Moreover, the probability of the threshold being met or exceeded is reflected in the premiums charged by the insurer. Typically, a lower scale on the index will result into higher premium and vice versa.
To demonstrate the above, we will consider an example. If a business is located in an area that is prone to natural catastrophes (e.g., southeast Turkey) the company would prefer to transfer the risk of natural disasters ceasing the continuation of their business activities to an insurance company. If an earthquake of a magnitude of 7.0 prevails and the pre-defined event parameter (e.g., 6.5) is exceeded, the insured will be paid out shortly without the need for the asset to be investigated by the insurance company or third party.
Why is it important? The recent natural catastrophes that occurred across the globe including the earthquake in Marrakech hitting a 6.8 magnitude causing thousands of people to be displaced from their homes and the hurricane in Libya highlights the significant impact that climate change has on society and businesses. Climate change is causing the number and intensity of natural disasters to increase significantly hence shifting a greater focus on climate risk resiliency. Therefore, creating a natural growing demand for businesses that are vulnerable to climate change to transfer risk to external parties which can be achieved through parametric insurance solutions offered by carriers such as Descartes Underwriting, Allianz RE and Munich Re among others.
To fully understand where parametric insurance and alternative data for climate resiliency fits in the insurance value chain, we will delve deeper into the insurance value chain and the respective business activities. The value chain can be decomposed into two chains namely, (i) new business generation and (ii) managing the existing business. The two separate chains are depicted below alongside their core activities in each respective step.
Figure 2: Insurance Value Chain: New Business Generation
In the next section we will discuss the new business generation value chain. Digital first parametric insurance start-ups (e.g., Yokahu) cover the entire value chain outlined above but their unique edge stems from the product development and underwriting process part.
In the space, the majority of insurtechs are either full stack carriers or managing general agents (MGAs) that leverage brokers to distribute their risk transferring products to corporates and governments. The start-ups tend to work with brokers for their product distribution strategy to achieve critical mass for cost efficiency and risk management purposes (the higher the number of policies, the greater benefit of risk pooling and diversification).
As a result, the start-ups can be viewed as direct competitors to the incumbent insurance carriers. The surge in digital newcomers can be explained through the advancement in technology and data analytics. The use of alternative climate risk data sources which is generated through proprietary technology or partnering with data providers (usually other start-ups!) provides a competitive edge for newcomers to enter, grow, and make their mark in the parametric insurance market. For example, Descartes Underwriting partnered with Reask (hurricane data analytics company) to enhance Descartes Underwriting’s parametric cyclone insurance product offering through the provision of Reask’s wind speed data (source: Descartes).
Figure 3: Insurance Value Chain: Managing Existing Business
Now we will discuss the ‘managing existing business’ value chain. Alternative data providers play a significant role in the actuarial monitoring and reinsurance part. But what is reinsurance? In simple terms, reinsurance is insurance for insurance companies. Basically, an insurance carrier transfers the risk of a previously underwritten policy to another insurance company (i.e., the reinsurer). There are several reasons why a primary carrier would want to transfer risk to another insurance company (i.e., purchase reinsurance). The reasons are outlined below.