The Transition from Traditional Coverage with Deductibles to Parametric Products is Inevitable and Beneficial for Everyone

Currently, the dominant form of insurance in most lines of business is traditional coverage with deductibles. With the deductible, an insurance company trims risks "from below," i.e., decreases its average claim by a fixed amount. However, with ever-increasing risk frequency and severity, this decrease is eliminated and has to be compensated by ever-growing deductibles.

The serious flaw of the deductible is the perception of it by insureds. The deductible itself is often associated with forgoing claims payment, and the reimbursement of the deductible amount is perceived as an additional cost on insurance.

This means that current products are neither profitable for insurance companies nor popular and desirable for clients. From a product strategy point of view, it is a dead end.

The new strategic trend for insurance product development lies in expanding parametric products, tested and proven successful in several niche markets, to become mainstream for most if not all, major lines of business.

Parametric insurance emerged and grew in areas with almost infinite maximum potential loss, like weather-related risks, or with extremely high claims management costs compared to the amounts of losses themselves, as in farmers' insurance.

But now it seems like parametric is ready to expand far beyond its current borders and previously made predictions, because is the only available and practical answer to the challenges that all P&C lines of business face, and it will be reasonable to predict that soon, we will see parametric products gradually replacing traditional ones in such lines of business as homeowners’ insurance and even auto insurance.

Parametric solutions solve profitability problems for the insurance industry. In contrast to coverage with deductibles, parametric products trim risks "from above," leaving insurance companies with de facto fixed liability. This liability, however, is paid instantly and without lengthy loss assessments, arguments, and litigations.

This is another advantage of this approach. Parametric insurance helps to fight social inflation, eliminating litigations, excessive payments, and high loss adjustment costs for insurance companies. According to various research, these alone might save 6-10% of the total amount of payments, compensating for the exclusion of deductibles.

Unlike deductibles, which motivate clients to "recoup the cost of insurance," i.e., to file the biggest claim possible, leading to reckless behavior and even soft fraud, parametric products cover fixed amounts of the risk, motivating insureds to stay within this limit and thus avoid or prevent highly risky situations and hence severe losses. This motivation will inevitably lead to the lowering of the overall risk profile or, given the trends, to relative stability in risk exposure.

The previous point also means that parametric products align well with usage-based solutions, which is unfortunately not the case with the previous product line.

Transitioning to Parametric Products: Key Considerations

First, how can the new approach be sold to clients? As much as clients are generally dissatisfied with existing insurance products (and even more with existing claims management procedures), they are used to them. Turning the product upside down and putting the client in charge of all the excessive risk will not be an easy pill to swallow. The best (if not the only) way to help this situation is to fully leverage the main advantage of parametric insurance: instant claims payments. It is well-known from behavioral economics that many people prefer to get less money instantly than wait for a bigger amount. To ensure really fast payments, significant changes in claims management processes and supporting technologies are inevitable.

Second, parametric insurance, by definition, is based on causation, not just correlation. Every parameter used in a product should be proven to be the direct cause or the precise measure of the insured risk. This will require more sophisticated data analysis than is currently in use and will necessitate not just more powerful data analysis capabilities but also integration with various data sources that will provide the necessary data.

At the end of the day, that doesn’t seem like too high a price for a solution that will allow the insurance industry to cope with seemingly unsolvable problems and return to profitable growth.

Is your company planning or undergoing the transition to widespread use of parametric products?