Spotlight on

Parametric Insurance
Just a New Hype or
a True Revolution
Matthias Rüfenacht
Spotlight on Parametric Insurance
Just a New Hype or a True Revolution
Introduction
The insurance industry holds a crucial role to protect
society from devastating risks. Increased insurance pen-
etration generally correlates with societal resilience, i.e.,
the easier insurance is available the better society is pro-
tected against hazardous events. However, traditional
insurance cannot cover all possible sorts of risks. This
fact is very well reflected by a growing protection gap
(Belghiti et al. 2023). The protection gap indicates the
delta between the amount of economically beneficial
insurance coverage versus the actual number of cover-
ages purchased (Schanz 2018). A Swiss Re sigma study
from 2022 offers a glimpse at the severity of the global
protection gap: Out of 275 billion total economic losses
due to natural catastrophes only 125 billion or 45 % were
insured (Banerjee 2023), leaving society behind with a
huge dead weight loss i.e., a decline in social welfare.
Given the fact that the numbers stated by Swiss Re only
focus on natural disasters and omit new types of risks
that arise due to a changing society (increasing popula-
tion in developing countries, decreasing workforce in
developed countries, changing customer needs etc.) and
technological progress (autonomous driving, AI etc.), we
can confidently assume that the comprehensive societal
protection gap may be even higher. In addition, the poor
are affected the most as being severely underinsured or
not insured at all (Kousky, Wiley, and Shabman 2020).
However, also in developed countries there is some sort
of underinsurance. E.g., in the United States almost 40 %
of the small businesses that suffered from flood damage
have never reopened again, mainly due to insufficient or
non-existing insurance coverage (Lin and Kwon 2020).
The reasons why this gap is of such enormous size are
manifold, such as affordability, awareness, appeal, avail-
ability, culture, trust and behavioral bias on the demand
side. On the supply side the factors of adverse selection,
transaction cost, limits to insurability etc. further exacer-
bates the problem. That is, among other reasons, insurers
clearly struggle to create products that fit customer
needs and cover new and arising risks (Belghiti et al.
2023). This explains the growing relevance of parametric
insurance as it is a means to mitigate some of the inher-
ent limitations of traditional insurance. With parametric
solutions specific risks that previously could either not
have been insured at all or if so, then at a very high
premium, can now be covered for reasonable premiums.
Thus, especially for low-income households these types
of coverages offer the only protection against severe
risks, such as natural catastrophes. In addition, the prod-
ucts can be customized specifically to the individual cus-
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tomer needs making parametric insurance a powerful
add on to traditional insurance. But what is parametric
insurance and what risks can be covered with this type of
coverage? Two aspects we will cover in the following.
What is parametric insurance and how does
it differ from traditional insurance?
Parametric insurance has emerged as an innovative and
promising product innovation in the insurance sector,
offering unique benefits and addressing certain
limitations of traditional insurance models. Unlike
traditional indemnity-based insurance, parametric
insurance relies on predefined parameters to determine
payouts, enabling faster claims processing and
enhanced risk management capabilities. In other words,
parametric solutions cover the probability of an
unfavorable event happening (Munich Re 2023). This
event could be a natural catastrophe, a shortfall in crop
yield or even a personal health risk, and is reflected by
objectively measurable parameters, i.e., windspeed,
millimeters of precipitation, blood pressure etc.
Parametric insurance can thus be defined as a type of
coverage that pays out a predetermined amount when
objectively measured parameters meet a predefined
threshold (the so-called trigger). Simply put, rather than
assessing individual losses on a case-by-case basis,
parametric insurance shifts the focus to objectively
measurable parameters, which serve as the only guide-
post to assess a claim.
As parametric insurance solutions differ in quite some
areas from traditional indemnity insurance, Lin and Kwon
(2020) define these types of coverage as non-indemnity
insurance. They further distinguish between three types
of parametric insurance (1) aggregate loss index insur-
ance, (2) Pure Parametric Insurance, and (3) Parametric
Index Insurance (See Figure 1).
1. Aggregate loss index insurance: These types of cov-
erage use an aggregate measure of loss of a region
which is used as a direct proxy for the individual
losses in that same region. A typical example is area-
yield crop insurance, where the shortfalls of a region
serve as a reference for the individual losses. Obvi-
ously, such coverages are easier to develop and
deploy compared to more complex solutions, such as
weather-based index products. However, aggregate
loss index insurance products are generally more
prone to inaccuracies and are less reliable.
2. Pure parametric insurance: These contracts pay out
a predefined amount when a covered event strikes
the threshold of a predetermined index (e.g., exceed-
Spotlight on Parametric Insurance
Just a New Hype or a True Revolution
ing a specified amount of rain in a covered area). The
payments are usually structured binary, that is, once
a trigger event happens the ex ante agreed payment
is executed regardless of the difference between the
modeled loss and the actual loss. As the complexity
of these products is fairly moderate, they are rather
easy to understand and deploy. In addition, a limited
amount of data is needed for these products making
them attractive in a low-premium, micro insurance
environment. However, an increased basis risk may
persist compared to a parametric policy where the
payout scheme moves with the underlying parameter.
3. Parametric index insurance: These types of paramet-
ric products are among the most complex ones. The
payout scheme mirrors the modeled loss in an
event-affected area, and actual payments are made
based on a parameter’s realization. With parametric
index insurance products multiple factors that affect
potential losses are juxtaposed with best-suiting
parameters. As previously mentioned, these cover-
ages have a high inherent complexity. However, as
data is becoming more accessible, such coverages
are facing an increasing demand.
Insurance
Indemnity/ Non-indemnity/
Insurance Insurance
Valued Policy Parametric
Insurance Insurance
Aggregate Pure Parametric
Loss Index Parametric Index
Insurance
Figure 1: Classification of non-life insurance types
(Lin and Known 2020)
Regarding private individuals, parametric insurance has
often been introduced to markets in the context of micro
insurance. Oftentimes these coverages for low-income
households are designed to protect them against spe-
cific perils, for which they could not afford a traditional
coverage, if it were even available. Thus, microinsurance
almost always comes in the form of a parametric
product (Kousky, Wiley, and Shabman 2020), offering cov-
erages to low-income households that otherwise would
more often than not end up with no insurance policy.
Given the efficient and affordable nature of parametric
insurance, it counters some of the reasons for a widening
protection gap, as stated above, and contributes to an
overall greater risk resilience for society.
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What sounds as a great and new innovation in the insur-
ance industry, has long been present in the sector in
various forms. Reinsurers are using parametric products
to cover natural disasters for many years. Since the mid-
1990s cat bonds have been extensively used to address
natural catastrophe coverage (Munich Re 2023). Even
more surprisingly, one of the earliest concepts of a trig-
ger-based insurance has been presented in a book from
Indian economist Chakravarti published in the 1920s.
Later in the 1950s first concepts of crop-yield insurance
have been developed where a shortfall in yield would
trigger a payout. However, not until the 1990s such index-
based insurances have been broadly applied. Technolog-
ical advancements such as improved predictive rainfall
models as well as satellite images made it possible to
use indirect indices, i.e., indices that are not directly
linked to the individual loss, thus boosting the applica-
tion of parametric insurance solutions (Lin and Kwon
2020).
The next chapter delineates the advantages and disad-
vantages of parametric insurance coverages in greater
detail.
Critical evaluation of parametric insurance
Advantages of parametric insurance
The unique characteristic of parametric insurance as
outlined above allows for faster claims settlement, redu-
cing the administrative burden for both insurers and poli-
cyholders, i.e., as soon as the thresholds are met (a
trigger event occurs), there is no need to further assess
the claim. The payout scheme kicks in and customers are
indemnified as soon as possible. The benefits are appa-
rent: transparency of coverage, fast settlement process,
flexibility of coverage tailored to customers’ needs (Swiss
Re 2018). Additionally, parametric insurance opens up
new avenues for coverage against non-traditional risks
that are challenging to assess through conventional
means, such as non-damage business interruption or
market fluctuations. To define and offer adequate poli-
cies for such risks, it is paramount that risk managers
thoroughly understand the business model of the insured
client. They have to understand the factors that affect
the business’ cash flows. For example, if a golf resort in
the tropics has only one bridge that connects it to the
mainland, that infrastructure is critical to the business,
and its collapse due to a hurricane would completely
disrupt the resort’s cash flows, even if the resort itself has
not suffered any destruction. Accordingly, parametric
products have to be customized in such a way that these
important infrastructure determinants are part of the
coverage. That can be done in this particular example by
Spotlight on Parametric Insurance
Just a New Hype or a True Revolution

defining windspeed thresholds within a given radius of Traditional indemnity

insurance Parametric insurance
the resort, something not possible under a traditional
indemnity insurance contract. Moreover, as the payout Payment Payment based on actual Occurrence of an event
trigger loss or damage to a that exceeds a parametric
amount is defined upfront, there is less tendency for insu-
physical asset threshold
rance fraud as with traditional indemnity insurance. This
Recover Reimbursement of the Pre-agreed payment
is also due to the fact that to occurrence of a trigger actual loss suffered structure based on event
event is verified by a third party such as a data provider parameter or index value
that monitors the index relevant for the policy. The trigger Trigger Loss or damage to insured Occurrence of a covered
is of course beyond the control of the insured. Thus, the subject matter event
typical problems with traditional insurance policies such Basis risk Based on policy condi- Based on correlation of
as moral hazard and adverse selection, can be control- tions, deductibles and chosen index, the pay-out,
exclusions and the loss sustained
led, albeit not eliminated, with parametric insurance pro-
Claims Complex and based on Transparent, predictable,
ducts.
process loss based on a parameter or
assessment index, quick settlement
In a nutshell, parametric insurance solutions can be used Risk of Medium to high Low
in situations where traditional policies may not adequa- adverse
tely cover a policyholder’s risk exposure by offering the selection
following key benefits: (1) faster payouts due to high Risk of Medium to high Low
claims automatization, (2) flexibility how the policy is moral
structured to cover the particular risk, (3) the possibility hazard

to provide coverage for difficult-to-model losses
(Sengupta and Kousky 2020), and (4) low risk of moral
hazard and adverse selection (Lin and Kwon 2020). Table
1 summarizes the differences between parametric insu-
rance and its traditional counter parts.
Despite the numerous advantages of parametric pro-
ducts, there are also certain downsides to consider,
which will be delineated in the next chapter.
Challenges of parametric insurance
As with any new product, a market entry is never an easy
task. First and foremost, consumers have to recognize
that the new product addresses their needs or at least
believe it serves them some intangible value or benefit.
While consumers are rather familiar with indemnity-
based insurance, the value of parametric products may
not be apparent at first glance. Thus, the link between
the parameter and the underlying risk has to be as easily
understandable and as transparent as possible for con-
sumers. As insurance products are generally sold and not
bought, insurance agents and risk managers play an
important role to distribute these types of coverages.
Especially in a corporate environment with complex risks,
risk managers need not only to persuade with a sophisti-
cated risk model but also with a thorough understanding
of the business model of the client company. Only an
integrated view of both dimensions will ensure sufficient
coverage based on customer needs and minimize the
basis risk, which presents already the next challenge to
consider with parametric insurance.
Term Usually annual policies Single or multi-year, or
even short-term
Structure Standard products and Customized product with
contract wordings, some high structuring flexibility
customization
Regulatory Generally in compliance Subject to the interpreta-
com- with local insurance law tion of local law and regu-
pliance and regulation lation
Table 1: Differences between traditional and parametric insurance
(Lin and Kwon 2020; Swiss Re 2023)
The basis risk is the risk that the chosen parameters do
not perfectly correlate with the underlying risk exposure.
Lin and Kwon (2020) define it as the difference between
the payment based on the set parameters (or the chosen
loss model) and the actual loss incurred of an insured.
Thus, clients could suffer losses without the parametric
insurance being triggered (Swiss Re 2023), which would
present a situation with a negative basis risk (Lin and
Kwon 2020). The insurer fails to compensate the insured
for the incurred losses. Even though a negative basis risk
scenario may be justifiable based on the concluded insu-
rance policy, it results in customer dissatisfaction and
renders parametric products less attractive. It may also
signal that the insurer is not capable of selecting an
appropriate risk model leading to reputational risks for
the insurer. On the other hand, a positive basis risk
defines a situation in which an insured receives a com-
pensation that is higher than the incurred loss or has not
even been affected by a loss event at all. Positive basis
risk reflects underpricing risks or charging insufficient
premiums from customers eventually leading to financial
losses and insolvency risks for the insurer. Accordingly,

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Spotlight on Parametric Insurance
Just a New Hype or a True Revolution
both basis risk scenarios need to be addressed by the
insurer and minimized. Therefore, it is paramount to build
parametric policies on reliable datasets as well as
setting up sophisticated risk models. Whatever parame-
ters are being selected as the trigger index, they have to
be highly correlated with the occurrence of a trigger
event. Another common practice to alleviate the risk of a
mismatch between an index and an event is to put
double trigger events into place or work with staggered
pay-out structures (Swiss Re 2023). Hence the basis risk
can be controlled and even limited but not fully elimina-
ted (Sengupta and Kousky 2020).
Moreover, parametric products are characterized by their
very efficient payout scheme, i.e., once a threshold is met
the payout happens immediately. While this circums-
tance is very beneficial to customers, it stands in con-
trast with established insurance practice. Per definition,
an insurance is a contractual relationship between an
insurer and a policyholder under which the insurer indem-
nifies the policyholder for any incurred losses covered by
the insurance policy in exchange for a premium. In order
to receive a payment for an incurred damage, the policy-
holder has to present a proof-of-loss when filing a claim.
Moreover, a basic proof-of-loss is also oftentimes requi-
red by regulators to distinguish insurance from derivati-
ves (Kousky, Wiley, Shabman 2020). This circumstance is
quite challenging for parametric insurance, as in its
simplest form a trigger event will automatically cause
the contractually agreed payment scheme to kick in.
Therefore, it is essential to cooperate with regulators and
define proof-of-loss statements for parametric products
that on the one hand comply with regulations, and, on
the other, are easy to attain and submit for policyholders.
For example, this could be a simple confirmation by text
message or email of an insured that a loss has been sus-
tained, given that regulators consent.
Finally, offering parametric insurance to private individu-
als is also challenging from a profitability perspective. As
mentioned above, parametric products are oftentimes
structured as micro insurance which targets low-income
households. Therefore, premiums have to be as low as
possible to reach those that need coverage the most. On
the other hand, parametric insurance for higher income
households that do not target essential protection
needs, such as flight delay, luggage delay or vacation
weather insurance may also not be sold at high premi-
ums, as the willingness to pay may be rather low to
moderate. By offering parametric products that fall into
these categories, insurers have to be aware that effi-
ciency in the insurance processes, automation and
scaling are critical. That is, cost have to be minimized by
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technology while as many clients as possible have to be
reached. Regarding the latter, cooperating with the
public sector to provide insurance for low-income house-
hold or gaining non-insurance companies as distribution
partners, such as travel agencies, and embed these new
parametric coverages in their customer journey, may be
two strategies that can be pursued to increase market
penetration.
Conclusion
In this paper we outlined the role of parametric insurance
as an innovative addition to the insurance market. Para-
metric insurance has the potential to counter the
growing protection gap, thus increasing the global risk
resilience. It partly offsets the problematic phenomena of
moral hazard and adverse selection and thus is a power-
ful tool to cover risks that would fall through in a traditio-
nal underwriting process. The predefined payout amount
and process greatly mitigate moral hazard and adverse
selection as the monetary compensation is fixed upfront,
and only hinges on the occurrence of a trigger event.
Once the predefined threshold of an index is met, no loss
assessment process is necessary, and payouts can be
done in a very fast and efficient manner. Therefore, para-
metric insurance can be a supplementary coverage to
cover underinsured areas of traditional insurance.
Another advantage that we have discussed is the poten-
tial of parametric coverages to be customized to the risk
exposure of an individual customer, which is done by defi-
ning the indices and setting the parameters according to
the risk propensity of that customer.
Moreover, parametric insurance can be applied to cover
very large risks such as hurricanes as well as in a retail
situation offering flight and luggage delay coverages. It
is this versatility that makes parametric insurance a
powerful tool for primary insurers as well as reinsurers.
However, parametric insurance also has its downsides. It
is more difficult to mitigate the basis risk as compared to
traditional indemnity insurance. We showed that both, a
negative as well as a positive basis risk is an unfavorable
situation for an insurer. Thus, sophisticated risk models
as well as sufficient data quality are essential for insurers
to minimize underinsuring or overpricing a parametric
coverage.
In conclusion, parametric insurance is here to stay to the
insurance market. It enriches the traditional landscape
and matures with increasing data quality and com-
putational power. New types of coverages are likely to
occur especially in the private client sector helping to
further narrow the protection gap.
Spotlight on Parametric Insurance
Just a New Hype or a True Revolution

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