Parametric insurance is a type of insurance contract that insures a policyholder against the occurrence of a specific event by paying a set amount based on the magnitude of the event, as opposed to the magnitude of the losses in a traditional indemnity policy. It is also known as index-based insurance. Parametric insurance policies offer pre-specified payouts based upon a trigger event, which can be any type of objectively measurable event that causes a loss and can be modeled. Trigger events depend on the nature of the policy, but they are often related to natural disasters, such as hurricanes, earthquakes, or floods. Parametric insurance policies have most frequently been implemented in developing economies, oftentimes for agriculture insurance.
The main benefit of parametric insurance policies is that they offer faster payouts than traditional insurance based on the nature of the trigger event. Because it is quick to verify if the trigger event passed the threshold specified in the policy, parametric policies can payout quickly. These quick payouts are especially beneficial for the liquidity to successfully recover after a disaster strikes. Parametric insurance can also be extremely beneficial in the wake of an economic loss, as the policies payout quickly and remove the claim adjustment process, helping to improve cash flow.
The most obvious downside to a parametric insurance policy is basis risk. The economic losses of the insured could differ by any margin from the amount of coverage, or the insured could have losses without the parameter being triggered. Accurately structuring and pricing the product requires a firm understanding of the exact exposures of the policyholder and carefully selecting the most appropriate parameter to fit those exposures.
Parametric insurance policies are not designed to replace traditional insurance but to complement them and speed up recovery. They can fill the protection gaps left by indemnity insurance like deductibles, excluded perils, scarce capacity, or pure financial risks where the insured has no control over the underlying asset. Parametric insurance policies are suited for hard-to-model, low-frequency but high-intensity losses as in catastrophic perils, weather-related risks in agriculture or other economic activities, and risks sought to be covered without sufficient history of losses captured as insurance-readable data.
