Parametric insurance: a newcomer but no longer a niche product

Currently, there is no legal definition or relevant regulations for parametric insurance in Austria. There is also no legal classification of the product under a specific insurance class. This is hardly surprising, as the financial market authority (FMA) did not publish a description of parametric insurance until 2019. But it did come up in a 2013 European Commission green paper on "Insurance against natural and man-made disasters" that described a parametric index-based insurance system as one in which compensation is paid for a loss caused by extreme weather events regardless of the actual amount when a given weather index deviates from the historical average.

So what is it?

The European Insurance and Occupational Pensions Authority refers to parametric insurance as "[...] a type of insurance covering the occurrence of a pre-defined external event, instead of indemnifying the actual losses incurred by the policyholder." It goes on to say that parametric claims allow for quicker distribution of funds and may be more suitable for immediate pandemic relief.

In 2021, expanding on its original 2019 statement, the FMA stated that with parametric insurance, "[...] the contract provisions are technically mapped on the basis of a blockchain in such a way that contract clauses can be partially or fully executed independently. This makes it obsolete to check whether the insured has actually suffered a loss and, if so, how much, because the agreed sum becomes due automatically as soon as a certain parametric trigger is reached."

In general, the FMA is now paying more attention to the full automation of processes through increasing digitalisation and the incorporation of new technologies, including in the insurance industry. Parametric insurance is one of several products that uses advanced technology and definitely needs to be watched closely. It covers the payment of a lump sum determined in advance by the insurer as soon as an event exceeds or falls below a predetermined threshold of a selected measure, without proof of a loss occurrence and a claim. In the case of household or home insurance, for example, the policyholder will receive a parametric benefit if a certain amount of rainfall or hale was measured.

It could be said that this approach invalidates the damage principle in insurance and hence the basic idea that damage covered by insurance should lead to the recovery and restoration of the original condition of the insured object. Instead, a certain amount of precipitation in a region, for example, leads to all affected households receiving an insurance benefit, regardless of the actual material damage suffered.

Areas of application

One of the most common applications of this product is the insurance of weather risks such as drought or heavy rain, heat or frost, but also flood and storm damage. It also offers the possibility of insuring risks that have not been insurable to date, but which may become increasingly important in the future, such as business interruptions without prior property damage, cyber risks, product recalls, and risks due to weather damage or energy prices.

The enormous volume of available data and the possibility of processing it within a very short time using the latest technologies, innovations from established market participants and new InsurTechs, the Internet of Things, distributed ledger technology like blockchain, etc. can also create huge potential for the further development and redesign of future parametric insurance solutions, either as an independent product or in combination with an already established product.

Legal classification still uncertain

Classifying parametric insurance as one type of insurance or another has consequences under both insurance contract law and supervisory law. To date, however, there has been no concrete classification.

Since parametric insurance does not relate to the life, health or physical integrity of people, it is a non-personal insurance. It is also not an aggregate insurance, because this is only allowed in personal insurance. In all other types of insurance, the insurer's payment must be based on a concrete disadvantage (in the sense of a concrete coverage of needs). Accordingly, it would have to be damage insurance in which the policyholder needs to prove some concrete disadvantage and the insurance benefit may not exceed the actual disadvantage suffered. This, however, contradicts the concept of the parametric insurance solution, as it is intended to prevent lengthy and costly claims settlement and to enable rapid access to liquidity. It also makes exceeding or falling below the thresholds defined as triggers for payment largely obsolete. Nevertheless, as with any other damage insurance, the policyholder must prove that a disadvantage has actually occurred.

Concrete coverage of needs is affirmed by some as the guiding principle of damage insurance. Section 55 of the Insurance Contract Act states that the insurer may only compensate the policyholder in damage insurance for the "amount of the damage", even if the sum insured is higher than the insured value at the time the insured event occurred. It is pointed out, however, that while the principle of specific needs coverage is important in insurance law, it is also not an end in itself, but serves the overriding goals of distinguishing an insurance contract from a gambling contract and of avoiding false incentives. Where these two dangers do not exist, abstract coverage of needs may be permissible by way of exception, even in non-personal insurance. A parametric insurance solution is therefore admissible if an economic need is covered and thus obviously no gambling contract is concluded. This classification would in any case make sense within the meaning of the parametric insurance solution.

To sum up, parametric insurance is interesting for policyholders not least due to the promise of a fast and unproblematic disbursement of a lump-sum pay-out determined in advance, without time-consuming and costly claims settlement and thus quick access to liquidity. It would also make it easier to insure against risks such as natural catastrophes or cyberattacks, which are becoming ever more frequent. On the other hand, the legal classification is still a challenge that needs to be overcome.

author: Marguerita Sedrati-Müller