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 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
The insurance industry holds a crucial role to protect coverage? Two aspects we will cover in the following.
society from devastating risks. Increased insurance pen-
etration generally correlates with societal resilience, i.e., What is parametric insurance and how does
the easier insurance is available the better society is pro- it differ from traditional insurance?
tected against hazardous events. However, traditional
insurance cannot cover all possible sorts of risks. This Parametric insurance has emerged as an innovative and
fact is very well reflected by a growing protection gap promising product innovation in the insurance sector,
(Belghiti et al. 2023). The protection gap indicates the offering unique benefits and addressing certain
delta between the amount of economically beneficial limitations of traditional insurance models. Unlike
insurance coverage versus the actual number of cover- traditional indemnity-based insurance, parametric
ages purchased (Schanz 2018). A Swiss Re sigma study insurance relies on predefined parameters to determine
from 2022 offers a glimpse at the severity of the global payouts, enabling faster claims processing and
protection gap: Out of 275 billion total economic losses enhanced risk management capabilities. In other words,
due to natural catastrophes only 125 billion or 45 % were parametric solutions cover the probability of an
insured (Banerjee 2023), leaving society behind with a unfavorable event happening (Munich Re 2023). This
huge dead weight loss i.e., a decline in social welfare. event could be a natural catastrophe, a shortfall in crop
Given the fact that the numbers stated by Swiss Re only yield or even a personal health risk, and is reflected by
focus on natural disasters and omit new types of risks objectively measurable parameters, i.e., windspeed,
that arise due to a changing society (increasing popula- millimeters of precipitation, blood pressure etc.
tion in developing countries, decreasing workforce in Parametric insurance can thus be defined as a type of
developed countries, changing customer needs etc.) and coverage that pays out a predetermined amount when
technological progress (autonomous driving, AI etc.), we objectively measured parameters meet a predefined
can confidently assume that the comprehensive societal threshold (the so-called trigger). Simply put, rather than
protection gap may be even higher. In addition, the poor assessing individual losses on a case-by-case basis,
are affected the most as being severely underinsured or parametric insurance shifts the focus to objectively
not insured at all (Kousky, Wiley, and Shabman 2020). measurable parameters, which serve as the only guide-
However, also in developed countries there is some sort post to assess a claim.
of underinsurance. E.g., in the United States almost 40 %
of the small businesses that suffered from flood damage As parametric insurance solutions differ in quite some
have never reopened again, mainly due to insufficient or areas from traditional indemnity insurance, Lin and Kwon
non-existing insurance coverage (Lin and Kwon 2020). (2020) define these types of coverage as non-indemnity
insurance. They further distinguish between three types
The reasons why this gap is of such enormous size are of parametric insurance (1) aggregate loss index insur-
manifold, such as affordability, awareness, appeal, avail- ance, (2) Pure Parametric Insurance, and (3) Parametric
ability, culture, trust and behavioral bias on the demand Index Insurance (See Figure 1).
side. On the supply side the factors of adverse selection,
transaction cost, limits to insurability etc. further exacer- 1. Aggregate loss index insurance: These types of cov-
bates the problem. That is, among other reasons, insurers erage use an aggregate measure of loss of a region
clearly struggle to create products that fit customer which is used as a direct proxy for the individual
needs and cover new and arising risks (Belghiti et al. losses in that same region. A typical example is area-
2023). This explains the growing relevance of parametric yield crop insurance, where the shortfalls of a region
insurance as it is a means to mitigate some of the inher- serve as a reference for the individual losses. Obvi-
ent limitations of traditional insurance. With parametric ously, such coverages are easier to develop and
solutions specific risks that previously could either not deploy compared to more complex solutions, such as
have been insured at all or if so, then at a very high weather-based index products. However, aggregate
premium, can now be covered for reasonable premiums. loss index insurance products are generally more
Thus, especially for low-income households these types prone to inaccuracies and are less reliable.
of coverages offer the only protection against severe 2. Pure parametric insurance: These contracts pay out
risks, such as natural catastrophes. In addition, the prod- a predefined amount when a covered event strikes
ucts can be customized specifically to the individual cus- the threshold of a predetermined index (e.g., exceed-

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Spotlight on Parametric Insurance
Just a New Hype or a True Revolution

ing a specified amount of rain in a covered area). The What sounds as a great and new innovation in the insur-
payments are usually structured binary, that is, once ance industry, has long been present in the sector in
a trigger event happens the ex ante agreed payment various forms. Reinsurers are using parametric products
is executed regardless of the difference between the to cover natural disasters for many years. Since the mid-
modeled loss and the actual loss. As the complexity 1990s cat bonds have been extensively used to address
of these products is fairly moderate, they are rather natural catastrophe coverage (Munich Re 2023). Even
easy to understand and deploy. In addition, a limited more surprisingly, one of the earliest concepts of a trig-
amount of data is needed for these products making ger-based insurance has been presented in a book from
them attractive in a low-premium, micro insurance Indian economist Chakravarti published in the 1920s.
environment. However, an increased basis risk may Later in the 1950s first concepts of crop-yield insurance
persist compared to a parametric policy where the have been developed where a shortfall in yield would
payout scheme moves with the underlying parameter. trigger a payout. However, not until the 1990s such index-
based insurances have been broadly applied. Technolog-
3. Parametric index insurance: These types of paramet-
ical advancements such as improved predictive rainfall
ric products are among the most complex ones. The
models as well as satellite images made it possible to
payout scheme mirrors the modeled loss in an
use indirect indices, i.e., indices that are not directly
event-affected area, and actual payments are made
linked to the individual loss, thus boosting the applica-
based on a parameter’s realization. With parametric
tion of parametric insurance solutions (Lin and Kwon
index insurance products multiple factors that affect
2020).
potential losses are juxtaposed with best-suiting
parameters. As previously mentioned, these cover-
The next chapter delineates the advantages and disad-
ages have a high inherent complexity. However, as
vantages of parametric insurance coverages in greater
data is becoming more accessible, such coverages
detail.
are facing an increasing demand.

Critical evaluation of parametric insurance

Insurance
Advantages of parametric insurance
Indemnity/ Non-indemnity/
The unique characteristic of parametric insurance as
Insurance Insurance outlined above allows for faster claims settlement, redu-
cing the administrative burden for both insurers and poli-
Valued Policy Parametric cyholders, i.e., as soon as the thresholds are met (a
Insurance Insurance trigger event occurs), there is no need to further assess
the claim. The payout scheme kicks in and customers are
Aggregate Pure Parametric indemnified as soon as possible. The benefits are appa-
Loss Index Parametric Index rent: transparency of coverage, fast settlement process,
Insurance
flexibility of coverage tailored to customers’ needs (Swiss
Figure 1: Classification of non-life insurance types Re 2018). Additionally, parametric insurance opens up
(Lin and Known 2020) new avenues for coverage against non-traditional risks
that are challenging to assess through conventional
Regarding private individuals, parametric insurance has means, such as non-damage business interruption or
often been introduced to markets in the context of micro market fluctuations. To define and offer adequate poli-
insurance. Oftentimes these coverages for low-income cies for such risks, it is paramount that risk managers
households are designed to protect them against spe- thoroughly understand the business model of the insured
cific perils, for which they could not afford a traditional client. They have to understand the factors that affect
coverage, if it were even available. Thus, microinsurance the business’ cash flows. For example, if a golf resort in
almost always comes in the form of a parametric the tropics has only one bridge that connects it to the
product (Kousky, Wiley, and Shabman 2020), offering cov- mainland, that infrastructure is critical to the business,
erages to low-income households that otherwise would and its collapse due to a hurricane would completely
more often than not end up with no insurance policy. disrupt the resort’s cash flows, even if the resort itself has
Given the efficient and affordable nature of parametric not suffered any destruction. Accordingly, parametric
insurance, it counters some of the reasons for a widening products have to be customized in such a way that these
protection gap, as stated above, and contributes to an important infrastructure determinants are part of the
overall greater risk resilience for society. coverage. That can be done in this particular example by

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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 Term Usually annual policies Single or multi-year, or
even short-term
(Sengupta and Kousky 2020), and (4) low risk of moral
Structure Standard products and Customized product with
hazard and adverse selection (Lin and Kwon 2020). Table
contract wordings, some high structuring flexibility
1 summarizes the differences between parametric insu- customization
rance and its traditional counter parts. Regulatory Generally in compliance Subject to the interpreta-
com- with local insurance law tion of local law and regu-
Despite the numerous advantages of parametric pro- pliance and regulation lation
ducts, there are also certain downsides to consider,
which will be delineated in the next chapter. Table 1: Differences between traditional and parametric insurance
(Lin and Kwon 2020; Swiss Re 2023)
Challenges of parametric insurance
The basis risk is the risk that the chosen parameters do
As with any new product, a market entry is never an easy not perfectly correlate with the underlying risk exposure.
task. First and foremost, consumers have to recognize Lin and Kwon (2020) define it as the difference between
that the new product addresses their needs or at least the payment based on the set parameters (or the chosen
believe it serves them some intangible value or benefit. loss model) and the actual loss incurred of an insured.
While consumers are rather familiar with indemnity- Thus, clients could suffer losses without the parametric
based insurance, the value of parametric products may insurance being triggered (Swiss Re 2023), which would
not be apparent at first glance. Thus, the link between present a situation with a negative basis risk (Lin and
the parameter and the underlying risk has to be as easily Kwon 2020). The insurer fails to compensate the insured
understandable and as transparent as possible for con- for the incurred losses. Even though a negative basis risk
sumers. As insurance products are generally sold and not scenario may be justifiable based on the concluded insu-
bought, insurance agents and risk managers play an rance policy, it results in customer dissatisfaction and
important role to distribute these types of coverages. renders parametric products less attractive. It may also
Especially in a corporate environment with complex risks, signal that the insurer is not capable of selecting an
risk managers need not only to persuade with a sophisti- appropriate risk model leading to reputational risks for
cated risk model but also with a thorough understanding the insurer. On the other hand, a positive basis risk
of the business model of the client company. Only an defines a situation in which an insured receives a com-
integrated view of both dimensions will ensure sufficient pensation that is higher than the incurred loss or has not
coverage based on customer needs and minimize the even been affected by a loss event at all. Positive basis
basis risk, which presents already the next challenge to risk reflects underpricing risks or charging insufficient
consider with parametric insurance. 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 technology while as many clients as possible have to be
insurer and minimized. Therefore, it is paramount to build reached. Regarding the latter, cooperating with the
parametric policies on reliable datasets as well as public sector to provide insurance for low-income house-
setting up sophisticated risk models. Whatever parame- hold or gaining non-insurance companies as distribution
ters are being selected as the trigger index, they have to partners, such as travel agencies, and embed these new
be highly correlated with the occurrence of a trigger parametric coverages in their customer journey, may be
event. Another common practice to alleviate the risk of a two strategies that can be pursued to increase market
mismatch between an index and an event is to put penetration.
double trigger events into place or work with staggered
pay-out structures (Swiss Re 2023). Hence the basis risk Conclusion
can be controlled and even limited but not fully elimina-
ted (Sengupta and Kousky 2020). In this paper we outlined the role of parametric insurance
as an innovative addition to the insurance market. Para-
Moreover, parametric products are characterized by their metric insurance has the potential to counter the
very efficient payout scheme, i.e., once a threshold is met growing protection gap, thus increasing the global risk
the payout happens immediately. While this circums- resilience. It partly offsets the problematic phenomena of
tance is very beneficial to customers, it stands in con- moral hazard and adverse selection and thus is a power-
trast with established insurance practice. Per definition, ful tool to cover risks that would fall through in a traditio-
an insurance is a contractual relationship between an nal underwriting process. The predefined payout amount
insurer and a policyholder under which the insurer indem- and process greatly mitigate moral hazard and adverse
nifies the policyholder for any incurred losses covered by selection as the monetary compensation is fixed upfront,
the insurance policy in exchange for a premium. In order and only hinges on the occurrence of a trigger event.
to receive a payment for an incurred damage, the policy- Once the predefined threshold of an index is met, no loss
holder has to present a proof-of-loss when filing a claim. assessment process is necessary, and payouts can be
Moreover, a basic proof-of-loss is also oftentimes requi- done in a very fast and efficient manner. Therefore, para-
red by regulators to distinguish insurance from derivati- metric insurance can be a supplementary coverage to
ves (Kousky, Wiley, Shabman 2020). This circumstance is cover underinsured areas of traditional insurance.
quite challenging for parametric insurance, as in its Another advantage that we have discussed is the poten-
simplest form a trigger event will automatically cause tial of parametric coverages to be customized to the risk
the contractually agreed payment scheme to kick in. exposure of an individual customer, which is done by defi-
Therefore, it is essential to cooperate with regulators and ning the indices and setting the parameters according to
define proof-of-loss statements for parametric products the risk propensity of that customer.
that on the one hand comply with regulations, and, on Moreover, parametric insurance can be applied to cover
the other, are easy to attain and submit for policyholders. very large risks such as hurricanes as well as in a retail
For example, this could be a simple confirmation by text situation offering flight and luggage delay coverages. It
message or email of an insured that a loss has been sus- is this versatility that makes parametric insurance a
tained, given that regulators consent. powerful tool for primary insurers as well as reinsurers.
However, parametric insurance also has its downsides. It
Finally, offering parametric insurance to private individu- is more difficult to mitigate the basis risk as compared to
als is also challenging from a profitability perspective. As traditional indemnity insurance. We showed that both, a
mentioned above, parametric products are oftentimes negative as well as a positive basis risk is an unfavorable
structured as micro insurance which targets low-income situation for an insurer. Thus, sophisticated risk models
households. Therefore, premiums have to be as low as as well as sufficient data quality are essential for insurers
possible to reach those that need coverage the most. On to minimize underinsuring or overpricing a parametric
the other hand, parametric insurance for higher income coverage.
households that do not target essential protection
needs, such as flight delay, luggage delay or vacation In conclusion, parametric insurance is here to stay to the
weather insurance may also not be sold at high premi- insurance market. It enriches the traditional landscape
ums, as the willingness to pay may be rather low to and matures with increasing data quality and com-
moderate. By offering parametric products that fall into putational power. New types of coverages are likely to
these categories, insurers have to be aware that effi- occur especially in the private client sector helping to
ciency in the insurance processes, automation and further narrow the protection gap.
scaling are critical. That is, cost have to be minimized by

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Spotlight on Parametric Insurance
Just a New Hype or a True Revolution

References

Belghiti, S., Brito,A., Javanmardian, K., Srivastava, A., Novo,

J.M. & Ramezani S. (2023). Global Insurance Report 2023:
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Kousky, C., Wiley, H., & Shabman, L. (2021). Can Parametric

Microinsurance Improve the Financial Resilience of
Low-Income Households in the United States? A Proof-of-
Concept Examination. Economics of Disasters and
Climate Change, 5, 301-327.

Lin, X., & Kwon, W. J. (2020). Application of parametric

insurance in principle‐compliant and innovative ways.
Risk Management and Insurance Review, 23(2), 121-150.

Munich Re (2023). Parametric solutions.

Schanz, K. U. (2018). Understanding and addressing

global insurance protection gaps. Geneva Association-
International Association for the Study of Insurance
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Sengupta, R., & Kousky, C. (2020). Parametric insurance

for disasters. Wharton Risk Center Primer. Wharton Risk
Center, Philadelphia.

Banerjee Ch., Bevere, L., Corti, Th., Finucane J. & Lechner, R.

(2023). Natural catastrophes and inflation in 2022: a
perfect storm. Swiss Re Institute. Sigma No 1/2023.

Swiss Re (2018). Parametric Solutions – Overcoming the

challenge. White paper.

Swiss Re (2023 July 7) What is parametric insurance?

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