Parametric Insurance and Artificial Intelligence: A Winning Combination for Climate Risk Management
Parametric insurance, despite its 200-year history, has been slow to gain widespread adoption in the insurance industry. Traditional insurers have often considered it a niche proposition, suitable only for the most challenging risks to insure. However, with the rise of inflation and increased climate volatility, conventional carriers are finding it difficult to underwrite in areas prone to growing losses. As a result, there is a growing interest in exploring alternative risk management solutions, especially those powered by artificial intelligence (AI). Market projections estimate that parametric insurance could reach $29.1 billion by 2032, indicating that this may be the opportune moment for its expansion.
Climate change-related disasters are not only becoming more frequent but also more devastating. In response, insurers are starting to recognize the value of parametric insurance. Unlike traditional insurance policies, parametric policies cover the probability of an event occurring. Once a specific trigger parameter is met, such as a hurricane of a certain strength at a particular location, the policy automatically pays out a predetermined amount. However, since parametric payouts are based on predetermined parameters rather than actual customer losses, there is a discrepancy known as 'basis risk.'
Historically, basis risk has presented a challenge to the adoption of parametric insurance. The complexities involved in designing parametric solutions, including pricing and data analytics, have made it difficult for insurers to implement them on a large scale. For instance, in the aftermath of Hurricane Maria in 2017, Puerto Ricans were left with $1.6 billion in unpaid insurance claims. This situation inspired entrepreneur Jonathan Gonzalez to launch Raincoat, an AI-powered company that partners with incumbent insurers to offer sophisticated parametric products across multiple perils. By leveraging neural networks and machine learning techniques, AI can analyze environmental patterns and enhance our ability to forecast and respond to events, whether sudden, like hurricanes, or progressive, like droughts.
Parametric insurance has seen the highest adoption rates in emerging markets where insurers prioritize keeping premiums and operating costs low. However, the combination of inflation and the increasing frequency and severity of climate-related catastrophes is now driving the rise of parametric insurance in mature insurance markets as well. Some incumbent insurers in the United States, facing a growing homeowner's insurance crisis, have decided to avoid risk in entire states. This has led to rapid growth in excess and surplus markets. By harnessing AI's predictive power, companies like Kettle provide commercial parametric wildfire products that rely on synthetic wind speeds created from real data points, eliminating the need for expensive hardware sensors on every building.
AI technology is also transforming the way flood risks are assessed. Fathom, a flood risk data company recently acquired by Swiss Re, utilizes AI to capture and model global drivers of extreme flood frequency and severity. Their AI-powered platform enables insurers and asset managers to interpret and evaluate flood risks beyond traditional statistical and historical approaches.
With natural disasters occurring three times more often than they did 50 years ago, the insurance industry is at a critical inflection point. Customers care less about whether their insurance coverage is considered parametric or not—they simply want better experiences, products, and greater protection. As predictive analytics and data sources continue to improve, the insurance industry will increasingly rely on the fundamentals of parametric insurance to enhance existing products. This evolutionary approach will lead to stronger risk management solutions that are innovative and responsive to the changing environment.
In conclusion, the combination of parametric insurance and artificial intelligence has the potential to revolutionize climate risk management. By minimizing basis risk through advanced AI solutions, parametric insurance can offer more comprehensive coverage and increase the speed and accuracy of claims processing. As the insurance industry adapts to our changing climate reality, embracing parametrics and AI will be crucial for creating stronger risk management solutions and fostering a more resilient future.
