Extreme weather events—such as heat waves, wildfires, hurricanes, and tornadoes—may create major protection gaps for insureds. In California, rising temperatures and massive heat waves have led the California Department of Insurance (the “Department”) to rethink risk solutions and insurance programs that protect the state’s communities from the risks associated with extreme heat. While the Department’s proposed solution applies only to coverage for local governments, Tribes, and public health agencies, it is a “hot” topic among many Californians, as insurance professionals and policyholders debate the Department’s proposed approval of parametric insurance.

Parametric insurance is a type of insurance contract that insures the policyholder against a specific event by paying a lump sum based on the magnitude of the event and avoiding what may often be a lengthy claims process. For example, a parametric policy may provide for a $100,000 payment if a tornado categorized as EF5 or higher occurs. Under this type of policy, the insurer pays the first-dollar losses, and the policyholder pays only the losses exceeding the parametric limit. A parametric policy differs from a traditional indemnity policy which (1) covers a multitude of risks, (2) obligates the insurer to pay the amount of loss incurred above the applicable deductible with payment capped by the policy’s limits, and (3) involves a claims assessment process that may materially delay payout of amounts owed.

But parametric insurance is not a replacement for traditional indemnity-based coverage. Instead, parametric policies are intended to supplement traditional insurance, such as indemnity-based homeowners coverage, by speeding up recovery of losses subject to the limits of the parametric policy which may only be a small portion of the overall losses. They also may be of benefit where traditional insurance is unavailable to cover certain risks. For example, in California, traditional insurers exited the market for earthquake insurance, and a form of parametric insurance was made available, at a substantial premium, for earthquake-related losses. Parametric insurance may also be a consideration for California now that at least two major insurers have pulled out of the state’s home insurance market. To underscore the point, parametric policies for particular risks would be in addition to the more traditional policies which, where available, cover multiple risks. 

With this concern and potential coverage gaps in mind, the Department’s proposed heat community policy relies primarily on a parametric underwriting approach. It involves a two-phase trigger criteria and a proof of loss. The first trigger is a physical measurement of a weather event. For California’s heat, the measurement could be a particular temperature, a particular temperature plus humidity, or a specific heat wave ranking. The second trigger concerns the severity, duration, or frequency of the event. The Department gives an example, stating that “to address severity, the policy could be limited . . . to heat waves that rank category 3 or higher.” Then, once the physical measurement and severity triggers are met, the policyholder has the burden of providing a proof of loss. The Department distinguishes its proposed proof of loss requirement from the proof of loss requirement for traditional indemnity insurance, describing the parametric proof of loss as “a significantly lower burden” because it does not require dollar for dollar accounting. Instead, the proof of loss is agreed upon in negotiations prior to the execution of the insurance contract (e.g., previously agreed upon steps the policyholder must take to reduce heat risks). The Department’s proposal incentivizes entities to create heat action plans, including calculating the amount of coverage needed to bridge gaps before loss occurs.

The debate surrounding parametric insurance—on both the insurer and policyholder side of negotiations—centers on several key advantages and disadvantages to parametric underwriting and parametric insurance policies.

The Department observes that there are various advantages to a parametric insurance approach for participating entities:

• Parametric insurance provides immediate liquidity following a severe weather event because the elimination of a claims adjustment process often leads to quicker payouts, allowing a policyholder to get “back to business” faster.

• The parametric approach allows policyholders to avoid increased deductibles as weather events become more frequent and severe because the policies do not have deductibles. Relatedly, under a parametric policy, a policyholder does not have to cover losses that would typically fall below a policy’s deductible.

• Parametric policies typically cover costs of disruption, even if the policyholder’s property does not have physical damage.

• Parametric insurance can be customized and used for a variety of risks beyond climate-driven events, such as cyber, data breach, and reputational damage. These types of risks often require an immediate response, making the quick payouts under parametric insurance a more suitable insurance solution.

The parametric approach, however, also has significant disadvantages for participating entities:

• A policyholder’s losses could fail to meet the necessary parameters to trigger coverage. For example, an extreme heat wave could cause significant business interruption loss but not rank high enough on the heat wave scale to trigger coverage.

• Parametric policies for particular risks do not take the place of traditional policies. They would be purchased at an additional cost.

• Parametric policies designed to provide immediate payout with no claims process may have extremely low limits.

• Principles of traditional indemnity insurance are deeply embedded within insurance law. There is limited regulation for parametric policies, and thus, limited protections and avenues of recovery for policyholders when an insurer wrongfully denies coverage.  

Given the advantages and disadvantages, a parametric insurance policy may complement the coverage needs of some commercial policyholders, but not others. As states, such as California, adopt new insurance solutions to respond to the financial risks and business disruptions caused by extreme weather events, policyholders should consult with experienced coverage counsel to ensure they are purchasing adequate coverage tailored to the business’s distinct coverage needs and exposures.