Damage compensation with classic, traditional types of insurance often involves a complex and prolonged process of determining the amount of damage. Moreover, the exact amount of damage is sometimes difficult to determine, and certain types of losses in certain cases are not even covered by the insurance policy, all of which represent the disadvantages of traditional types of insurance that reflect unfavourably on the insured. In response to these shortcomings, parametric insurance was invented, which represents the most recent innovation in the world of insurance.
Parametric insurance, or index-based insurance, represent a type of insurance that implies the payment of a pre-agreed amount of compensation in the event of the occurrence of a certain event. Therefore, with parametric insurance, neither the payment of compensation, nor its amount, depends on the damage that actually occurred, which represents the essential difference between this type of insurance and traditional types of insurance.
For the stated reason, parametric insurance is most often used to insure business results in activities in which the success of a business venture is related to weather conditions, such as: agriculture, electricity production, construction, transport of goods and passengers, etc.
How does parametric insurance actually work? First of all, the insurer, and the insured, based on the already known facts of the specific case, potential risks, and other relevant data, agree on the objective parameters of the event, on whose occurrence in the future the payment of compensation depends, which is also agreed in advance. The mentioned parameters are set in such a way that they can be objectively measurable but are nevertheless adapted to the needs and circumstances of the insured or insured’s business, and especially to the degree of exposure of the insured to adverse events and insured’s degree of risk tolerance. After contracting the parameters, a third party is engaged in charge of monitoring them and providing relevant information about the achievement of the parameters. In this way, objectivity is ensured at the highest level, since in this case neither the insured nor the insurer have the possibility to influence the payment of compensation or its amount.
Parametric insurance in practice looks like this: if the insured is a company engaged in construction, it could be agreed that compensation should be paid in the event that a certain area where the insured operates is hit by an earthquake of magnitude 5.0 on the Richter scale or stronger official report of the Republic Hydrometeorological Institute of the Republic of Srpska.
Therefore, if the agreed parameters are actually achieved or exceeded, and if the third party confirms the occurrence of an event that represents the “trigger” of the payment mechanism, the insurer will pay the insured the agreed compensation, regardless of whether the damage occurred.
This type of payment mechanism enables quick payment of compensation, which is the main advantage of parametric insurance compared to traditional types of insurance. In addition, bearing in mind that the compensation payment is not connected to the resulting damage, this new type of insurance allows the insured to address the paid funds to where they are most needed from his point of view. Finally, due to its flexibility and wide field of application, parametric insurance has proven to be particularly useful because it enables protection in situations where the client cannot be protected by existing types of insurance.
As it might be expected, parametric insurance is not without its drawbacks. Bearing in mind that the payment of damages depends on the occurrence of a certain event, it is crucial to determine the parameters adequately and properly, because this is precisely what the payment of compensation depends on. In addition, with parametric insurance, there is always a risk that the compensation paid will not be sufficient to compensate the actual damage. This risk can be avoided by contracting one of the traditional types of insurance for compensation of actual damage, whereby parametric insurance serves as supplementary insurance and provides absolute protection to the insured.
Although parametric insurance is not yet present on the insurance market of Bosnia and Herzegovina, it is becoming more widely represented on foreign markets, which is why it can be expected that it will soon come into practice in our area as well.
Author: Jelena Milinkovic
E-mail: [email protected]