Parametric Insurance: The next big capital pool in DeFi – The opportunities to harness the power of blockchain and adapt it to insurance solutions seem endless. Let’s talk about parametric insurance and why this is blockchain’s next gateway for new users.
What is Parametric Insurance?
Conventional insurance indemnifies the policyholder for the loss it incurs from an insured event. Due to the inherent subjectivity of those assessments, there is a mutual distrust between policyholders and insurers that results in troublesome lengthy disputes for claimants.
Parametric insurance by contrast pays a fixed amount upon the occurrence of a triggering event measured or declared by a neutral third party on whom the insurer and insured agree (premiums are based on the significance of the event rather than on the economic losses).
We can think of the payout structure of parametric products as an “if-then” logic model where the premium pricing is based on a modeled forecast of the loss probabilities that the policyholder will incur (risk assessment).
For example, a parametric insurance contract may imply that regardless of the actual economic damage, an insurer will pay $1m to a policyholder if an earthquake goes above a specific magnitude value and reaches a particular territory. No loss adjusting needs to take place. If the predetermined threshold has been met, the policy is triggered and payment is made.
As you can probably tell, data is key with parametrics and that’s why new indices based on datasets are constantly being researched and deployed like Internet of Things (IoT), satellite imagery, sensor-based systems or Artificial Intelligence (AI) to expand product offering & improve risk modeling.
Workflow of a blockchain-powered weather parametric insurance platform, Arbol
Advantages to Parametric Insurance
We have detected 3 main areas where parametrics excels traditional insurance: certainty, speed, and cost-effectiveness.
- Certainty because coverages are automatically activated when data from objective third-party sources exceed previously agreed thresholds. In other words, customers know how much they will receive once certain conditions are met. And since there is no lengthy loss assessment process required, they can expect payment to be made in days or, at most, weeks in web2.
- Parametric insurance is elegant in its simplicity. The big win of parametric insurance is their potential for efficiency and automation (streamlined underwriting). Claims handling, one of the most complex and costly parts of the operation of an insurance business, can be reduced to a simple and fully automated process.
- This model also helps to minimize costs, as claims managers, lawyers and other technical specialists are not needed to assess losses. Additionally, potentially fraudulent claims are not a problem for these policies, as the insurance program is based solely on independent data sources.
Parametric Insurance In DeFi
The growth of parametric insurance in recent years has been driven in large part by the increased availability of data and analytics. Previously, significant basis risk prevented parametric insurance from scaling beyond large-scale reinsurance transactions.
According to Clyde & Co, adoption growth and consumer interest in parametric might be at risk as some regulatory and legal uncertainty remains. Parametric insurance products are relatively novel and regulatory frameworks don’t exist in multiple regions so the model remains largely untested and unreachable for many (protection gap).
Luckily we have blockchain and it’s safe to say that parametric insurance powered by smart contracts represents a disruptive mindshift for the entire insurance industry.
As Chainlink states: by combining blockchains, the smart contracts built on top of them, and decentralized oracles, it’s possible to upgrade the foundational infrastructure of insurance to not only solve the problem of transparency but also streamline the entire insurance process and make insurance globally accessible to disenfranchised consumers.
It doesn’t matter where you’re from, either peruvian, vietnamese or american. When using blockchain for these processes, the only thing you need is a crypto wallet. Underwriting is democratized while products reach massive scalability.
One of the main areas of concern cited by skeptics in DeFi insurance, “the lack of real-world bridges”, is being addressed in real time. Projects like Verso onboards non crypto native companies on-chain like Koala. We are certain that laying a blockchain-enhanced foundation today can place a company ahead of its competitors and in a position to capitalize on the rapidly expanding acceptance and adoption of this space.
Moreover, with the proliferation of BaaS (Blockchain as a Service) platforms, it’s becoming increasingly more affordable to launch blockchain solutions even for relatively traditional small industry players, thus enlarging product offering in the parametric insurance market.
Today, web2 insurance claims payment process still largely relies on an adjuster’s subjective assessment of damages and loss. And even DeFi insurance protocols have a fundamental design flaw that some individuals have used to their advantage. Governance members, in some of these protocols, are allowed to decide when payouts are made.
In the end, the decentralized finance world is fast-paced, meaning that it needs a fast, innovative, and scalable insurance solution to thrive. This presents the opportunity for parametric insurance to solidify itself as the future of DeFi and removes the inefficiency of traditional insurance protocols as the standard. Now, processing times, policy parameters, and even pricing can all happen on-chain in a way that is completely transparent to all parties.
Smart Contracts, Web3 and Parametrics
Smart contracts are programs stored on a blockchain that can be coded to run when predetermined conditions are met. They can automate the execution of an agreement so that all participants are certain of the outcome, without any intermediary’s involvement. Smart contracts are a blockchain-based innovation that offer a great opportunity for insurers to offer their customers efficient parametric insurance solutions.
With a smart contract, the insurer creates a program that automatically pulls rainfall data from oracles with a predetermined trigger point and automatic instantaneous claim payment transactions.
The production of DeFi parametric insurance is generated in a decentralized infrastructure.
With web2, the efficient exchange of digital information led many to appreciate the potential use cases for peer-to-peer information exchange. With web3, consensus leads many to contemplate the potential use cases for peer-to-peer value exchange.
Insurance underwriters in parametric insurance, can create insurance risk pools laced with particular parameters and can also provide liquidity for them as well. The parameters usually include the amount that users will pay as premiums, what the payout ratios are, as well as the events that are insured. Investors provide collateral for risk pools in exchange for interest payments.
Etherisc insuring Kenya farms
Within parametric insurance, there are many common flavors with area-yield and weather parametric insurance being the two most common ones. Weather-related events are not coming to an end any time soon, and they often leave entire communities broken and in need for hedging.
The International Monetary Fund concluded that only about 30% of losses from natural catastrophes have been covered by insurance in the past ten years. In middle or low-income countries the uninsured proportion of economic losses often exceeds 90%.
Many dapps are already on top of this protection gap. One of the biggest news in the space took place at the beginning of the year when Etherisc joined forces with Lemonade and other blockchain, insurance and DeFi leaders to launch the newLemonade Crypto Climate Coalition. A joint initiative to offer decentralized parametric insurance for crop insurance in emerging markets.
However, predetermined trigger events don’t have to be weather-related risks. Parametric insurance can be applicable to any scenario with an objective dataset. Flight delays, energy consumption, health, cyber and any interruption caused by problems in the supply chain can also be covered.
On-chain parametric insurances allow for modular product creation, where if data is available to trigger a claim from a smart contract, the limits for product creation become minimal. As on-chain liquidity becomes generalized, the amount and variety of protection products that will be created will increase dramatically.
We will be able to hedge against risks in our daily lives, which we cannot do nowadays because the infrastructure is not in place yet. Once the base for creating any protection product is there, the exchange of value between insurers and insured parties will expand to all kinds of spheres.
This not only applies for insurances, but for other products such as derivative contracts, that would allow someone to hedge against adverse gas prices, for example.
The only limit becomes the demand for such products and the creativity of their creators.