Application of Parametric Insurance in

∗
Principle/Regulation-Compliant and Innovative Ways

Xiao (Joyce) Lin † W. Jean Kwon ‡

July, 2019

Abstract

This paper offers a comprehensive review of parametric insurance from a contractual

viewpoint. We propose a new categorization of parametric insurance. We then outline
the benefits and concerns of parametric insurance in comparison to indemnity-principle
based insurance, and discuss the regulatory compliance matters. There has been a rise
of innovative parametric insurance solutions in recent years covering a wide range of
risks and serving clients from individuals, to businesses, and to governments. We
survey the current global market and identify areas where insurance and reinsurance
companies can play important roles in offering or supporting parametric insurance
operations. Lastly, we offer a case study on a type of parametric insurance designed to
cover earthquake risk in California.

∗
This research is funded by Lloyd’s of London.
†
Corresponding Author. St. John’s University. [email protected]
‡
St. John’s University. [email protected]

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1 Introduction
The nonlife insurance industry uses two broadly accepted principles - the indemnity principle
and the valued policy principle (also termed as the non-indemnity principle) - to set the scope
of the insurer’s claim payment obligations.1 The more common of the two is the indemnity
principle, under which the coverage is triggered when an insured sustains an actual economic
loss of or damage to the subject matter of insurance and the claim payout is mainly for
restoration of the insured to an actual or potential financial position the insured had prior
to the loss event, subject to policy limits, conditions and exclusions.2 This principle fits well
with typical products in property, marine, aviation and transportation (MAT) and liability
lines of insurance where the loss exposure can be estimated statistically significantly and the
actual loss verified objectively.
Nonlife insurance can be written on the valued policy principle under which, upon the
occurrence of a covered event, the insurer compensates the insured a fixed or scheduled
amount that it agreed with the insured at policy inception. The amount may be adjusted
as agreed on a priori for a partial loss but does not vary a posteriori to the actual economic
loss. Valued policy insurance also requires the presence of insurable interest at the time of
loss as well as a verification of an actual economic loss. This principle fits well when the
subject matter of insurance is unique and a statistically significant loss estimation is not
readily available (for example, one-of-a-kind property) or when the insured needs coverage
for incidental expenses as in, for example, travel insurance and personal accident insurance.
Accordingly, the valued policy principle has been applied to a relatively narrow scope of
products in the nonlife insurance market.
1
Traditional reinsurance contracts are generally based on the indemnity principle because reinsurance is
in principle for the recovery of part of the claims paid by the insurance company. Nonetheless, modified
approaches are observed not only in insurance and reinsurance markets but also in ILS and other alternative
risk transfer (ART) markets, which include but are not limited to indemnity triggers and industry loss (also
known as pooled-indemnity) triggers (for example, RMS, 2012; MacMinn and Richter, 2018).
2
The claim settlement in property insurance is commonly on an actual cash value method (commonly,
replacement cost minus depreciation of the insured property) or on a replacement cost method (that is, with
no deduction for depreciation of the property). Use of the latter method, therefore, can result in cases of
over-indemnification. However, such gains are not only accidental but also consequential to the occurrence
of a loss event which is beyond the control of the affected insured.

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 With the growing economy and increased concentration of loss exposures, non-life in-
surance consumption worldwide has risen. Nonetheless, not all losses are covered and the
issue of the “protection gap” remains significant. There are several methodologies for the
measurement of the protection gap. Swiss Re (2018b) reports the protection gap - defined as
the difference between economic losses and insured losses - to be around $193 billion in 2017.
It also reports that the growth rate of economic losses outpaced the growth rate of insured
losses during the 1991-2017 data period; in terms of 10-year moving averages, insured losses
and economic losses grew by 5.4% and 5.9%, respectively, during the period.
Lloyd’s defines the protection gap as “the value of assets at risk not covered fully by
insurance” or alternatively as “the value of assets not covered for damage caused by a
catastrophic event.” Lloyd’s (2018) reports that the global insurance gap is hardly closing
- at $162.5 billion in 2018 - a reduction of only about 3% from the gap of $168 billion in
2012; emerging economies accounted for 96% of the gap. Lloyd’s also reports that, while
managing the gap is critical in developing economies, four developed economies (Japan,
Russia, the United Arab Emirates and Sweden) are identified as underinsured in the 2018
report. Separately, the US National Flood Insurance Program (NFIP) reports that almost
40% of small businesses never reopen after experiencing flood damages. The rise of the
protection gap resulting from sub-optimal or non-consumption of insurance in developing
and developed economies thus remains a critical issue from a societal risk management
perspective as well as from an insurance market perspective.
The widening protection gap is partly affected by the prevailing political, economic,
social, physical, and insurance market environments (Holzheu and Turner, 2018). At the
same time, the gap exposes some inadequacy in the current risk underwriting practice and
insurance contract design. For example, insurers attempt to reduce the cost of insurance
by eliminating small claims with a deductible provision, by requiring insureds to share the
loss with a coinsurance provision - thus reducing moral hazard problems and the cost of
insurance, and by setting minimum and maximum coverage limits to manage efficiently their
risk portfolios. Besides, insurers conduct rigorous underwriting for effective risk selection
and classification (that is, to reduce adverse selection problems) as well as a comprehensive

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assessment of claims for verification of the covered loss (for validation of the presence of
insurable interest).3
Parametric insurance can offer a new opportunity to solve some protection gap problems
while making the insurance market more effective in managing claims. Parametric insurance
(also known as index insurance) refers to an insurance contract under which the insurer
becomes responsible for the payment of an ex-ante agreed or scheduled amount once a
parameter has reached the contract-defined threshold. Any risk with only a loss outcome
- thus excluding speculative risks - can be a candidate for parametric insurance as long as
a statistically significant correlation between the loss event and the insurance payout can
be established. Parametric insurance can be designed to cover the risks that are currently
underwritten by indemnity or valued policy principles, for example, direct property damages
and consequential losses of income, and additional operating expenses caused by a natural
or man-made peril. In addition, parametric insurance can be designed to insure those risks
which are deemed uninsurable in the conventional insurance market, for example, a loss
of revenue or a rise in operating expenses but without any direct physical damage to the
insured property. The insurers benefit from an immediate release of their capital holdings
as parametric insurance claims are short-tailed by design. Buyers of parametric insurance
benefit from an additional or new layer of insurance coverage and receipt of fast claim
payments.
This paper examines parametric insurance as a type of non-indemnity insurance con-
tract, yet not identical to insurance policies written based on the valued policy principle.
It also examines the benefits of parametric insurance, as well as some practical concerns
including regulatory and legal concerns. In evaluating parametric insurance as an innovative
approach to managing the protection gap, we identify key market segments where insurers
3
We offer an alternative explanation about the behavior of indemnity insurance writers. The insurer faces
its own basis risk that its loss expenditure can be greater than its premium income. As an attempt to reduce
this basis risk, insurers attempt to best estimate their loss exposures via, among others, comprehensive
underwriting and claims investigation practices. As a result, indemnity insurance coverages come with a
heavy loading for underwriting and loss adjustment expenses. The presence of this basis risk can thus cause
sub-optimal or non-consumption of indemnity insurance. Besides, the comparatively weak transparency in
risk underwriting/pricing schemes, delays in claims settlements and occasional differences in loss valuation
may induce lower-than-expected consumption of indemnity insurance.

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and reinsurers alike may participate in underwriting risk or providing services.
No academic papers are known to offer a comprehensive review of parametric insurance
from a contractual viewpoint. Existing studies discuss one type of parametric insurance at
best - weather index insurance for agricultural risk management (for example, see Cole and
Xiong (2017) for a review of research on agricultural insurance). This is not surprising as
the earliest form of parametric/index insurance was developed to help farmers manage crop
yield risk due to bad weather. In recent years, however, we witness a rise in popularity of
parametric insurance, in managing risks from natural catastrophe to man-made incidence,
and from physical asset protection to revenue or income protection. Therefore, a structured
discussion of parametric insurance including the application of legal principles into it and
validation of market practices is warranted.
This paper contributes to the understanding of parametric insurance from the insurer’s
and regulator’s perspectives. Prior literature focuses on understanding the demand for such
insurance, especially among the population in developing countries with no or limited prior
exposure to financial or risk management products (Gaurav et al., 2011; Dercon et al.,
2013; Cole et al., 2013). Researchers find that demand typically is low and faces constraints
such as liquidity constraint, lack of trust, lack of interest and limited salience; on the other
hand, demand can be increased through financial literacy education, recent experience with
a payout, or certain type of marketing intervention. Prior literature also finds that the
demand for weather index insurance among farmers in developing countries is a complement
to informal risk sharing, but is a supplement to other forms of labor wages (Cole et al., 2014;
Cole et al., 2018). Little is understood, however, about the supply side of the market, or
beyond the agricultural segment. This paper fills in the gap in the literature, by examining
the supply side of parametric insurance, and by offering examples of application in agriculture
and beyond and in developed as well as developing economies.
The rest of this paper is organized as follows: the next section gives an account of the de-
velopment of parametric insurance and proposes a new classification of all types of parametric
insurance contracts. Sections 3 and 4 elaborate on the benefits and concerns of parametric
insurance, including a discussion of legal principle and insurable interest. Section 5 provides

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a comprehensive survey on existing parametric insurance programs worldwide, by classifying
them into micro, meso and macro-type programs based on the type of policyholders they
serve. Section 6 offers a closer look at a case study on a micro-type parametric insurance
against earthquake risk. Section 7 concludes with a discussion.

2 The Development and Categorization of Parametric

Insurance
The idea of using a parametric trigger - also known as an index or weather-indexed trigger
- in insurance is not new. Singh (2008) documents the efforts in India for the design of a
rainfall index-based agricultural insurance program in the early 20th century. Specifically,
Chakravarti began working on formulae of rainfall and crop output in 1915 and came up
with a proposal to measure the deficient or excessive rainfall which affects crop output. He
published a number of writings including a book in 1920 “Agricultural Insurance: Practical
Scheme Suited to Indian Conditions.” However, his scheme was never implemented due
mainly to the technical difficulty in rainfall measurement.
Later, Halcrow (1949) proposed an area-yield concept for the US federal insurance pro-
gram. Under his concept, the coverage would be triggered when the mean area-yield for the
year fell below a specified level (for example, a percentage of the expected or normal yield
for the area) and each insured had an option to purchase full coverage (that is, the entire
difference between the mean and actual yields) or part of it (for example, 80% of the differ-
ence). He also proposed a weather-index crop insurance coverage under which the insurer
would compensate the insured when the index exceeded a “certain limit of tolerance” (for
example, rainfall below a threshold in an area with an average of 25 inches). He emphasized
that the index must be measurable. There had been sporadic proposals and experiments
in the past, including the introduction of crop area yield index insurance in Sweden in the
early 1950s.
It was only in the late 1990s that the idea of index-based insurance became practical.

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The United Nations and its agencies have been pivotal in running a number of index-based
agricultural and livestock insurance programs. The International Fund for Agricultural De-
velopment (IFAD) and World Food Program (WFP) of the United Nations published a
report in 2010, summarizing a number of index insurance programs for either disaster relief
or agricultural development, covering cases in Mexico, India, Ethiopia, China, Canada, US,
Ukraine, and Brazil (IFAD and WFP, 2010). The World Bank Group in 2009 launched
the Global Index Insurance Facility (GIIF) to promote the use of index insurance as a risk
management tool in agriculture, food security and disaster risk reduction. The World Bank
supported programs include the Caribbean Catastrophe Risk Insurance Facility (CRIF), the
African Risk Capacity (ARC), and the Pacific Catastrophe Risk Assessment and Financing
Initiative (PCRAIF).
Parametric insurance products during the early 21st century were often developed as an
alternative solution mainly for the poor in developing economies who never had access to, or
could not afford, indemnity principle-based private insurance. Local governments - alone or
working with an intergovernmental agency or a non-profit organization - led the introduction
and expansion of the programs. They provided support for infrastructure development and
offered premium subsidies in a number of programs. Private insurance companies were
invited to participate in selected programs. Public sector-led parametric insurance programs
are still widely observed around the world to this date.
The role of private insurers has significantly expanded in recent years, due to the increased
availability of quality data, and advances in information technology and modeling techniques.
Insurance companies have accumulated experience and expertise in product modeling and
basis risk management. Accordingly, private companies have become increasingly active in
offering innovative parametric insurance coverages to the general public - individuals and
corporations alike. They also remain active in working with local governments and regional
government pools.
Classification of Parametric Insurance. We classify all existing parametric insur-
ance programs into the following three categories in this paper. See also Figure 1 for the
classification of nonlife insurance contracts including the following three types of parametric

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insurance.
Figure 1: Classification of Nonlife Insurance Contracts.

• Aggregate loss index insurance refers to a contract where the claim payment is based
on a parameter (index) - usually some aggregate of the loss of an area or region - which
serves as a proxy for individual losses. It is assumed that there are a sufficient number
of relatively homogeneous risks in the area and the losses of individual insureds are
closely related to the average loss of the covered region (Carpenter, 2018). It is the
simplest form of parametric insurance where the trigger is commonly set in reference to
the outcome of covered activities in the entire area or region (for example, individual
harvest vs. average harvest of the region or individual livestock mortality vs. average
mortality of the region). Skees (c.2012) notes that “insurance against bad weather
rather than bad harvests” that is underwritten based on “area yields rather than farm-
level yields” could be an economically sustainable and affordable solution for the poor
in developing economies.

• Pure parametric insurance refers to a contract where the insurer makes a pre-determined
payment when a covered event strikes a specific trigger (for example, a wind exceeding

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 a specified speed in the covered area). The payment is commonly binary, meaning that
the insurer pays a fixed amount regardless of the difference between the modeled loss
and the actual loss of each of the insureds. This product is simple to structure and can
be used to protect people against relatively small loss exposures. The insurer may set
the policy limit low which is just enough to cover the deductible in indemnity insurance
covering the same risk. It has been used in selected micro-risk parametric insurance
programs that require a low premium outlay and an easy-to-understand trigger.

• Parametric index insurance refers to a contract in which the parameter, the claim
payment structure and pricing are model-driven. A typical model for this purpose
analyzes the combining effect of multiple factors for loss estimation and parameter
setting. Accordingly, the claim payment is made according to the modeled loss in the
event-affected area. Use of this type of product is rising in the parametric insurance
market.

3 Benefits and Concerns of Parametric Insurance

Parametric insurance offers a number of benefits as compared to indemnity and other exist-
ing insurance policies, as well as some drawbacks. As summarized in Table 1, it is flexible in
risk coverages, can be cost-effective and has limited exposure to problems of adverse selection
and moral hazard. On the other hand, insurers considering entering the parametric insurance
business need to be aware of the risks specific to the business (such as basis risk manage-
ment) as well as regulatory and legal concerns (such as insurable interest requirement). We
elaborate on the key benefits and concerns below.
We first elaborate on the key benefits as follows.

• Flexibility and simplicity in product design and risk accommodation. Parametric insur-
ance has the potential to cover any fortuitous and non-speculative risks, provided that
the contract satisfies the local insurance regulation. It can be designed for a group of
individual insureds and can also be customized for each large client or risk pool be-

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 Table 1: Comparison of Indemnity Insurance and Parametric Insurance

Indemnity Insurance Parametric Insurance

Covered risks Typically insurable risks; Risks can be named or Any risks that are fortuitous and (by itself)
the coverage can be comprehensive non-speculative and can satisfy local insurance
regulation; Named risks only
Product design Ranges from standardized templates Commonly customized coverages and
(personal lines) to complex, customized coverages tailored to the specific needs of the
(large, commercial lines) insured or a group of insureds
Trigger Loss or damage to the subject matter of insurance Occurrence of a covered event
Insurer obligation Repair or replacement of the actual Pre-determined payment in cash or equivalent
damage sustained or reimbursement of the
actual loss sustained
Coverage period Commonly annual Commonly seasonal (for weather-risk or
crop-based coverage) or annual; possible

10
multi-year contract
Claim investigation Based on loss assessment Prompt and transparent payment because of
no requirement of practical loss assessment
Recovery method Replacement, repair or cash (or equivalent) Cash (or equivalent)
Policy transparency Low High
Underwriting Extensive Simple
Adverse selection Medium to high Low
Moral hazard Medium to high Low
Basis risk Policy conditions, exclusions and policy limits Correlation of the model-based loss (or the
payment) to the actual loss sustained

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Basis risk level Low Medium to high
Regulatory compliance Generally in compliance with local insurance Subject to the interpretation of local law and
law and regulation regulation
Source: Author compilation
 cause the model is based on the frequency analysis of a statistically sufficient number
of covered loss events. The claim payment options do not include a “repair or replace-
ment” as in indemnity insurance and insureds are free to use the payment in cash or
equivalent for recovery of asset or revenue loss or for any other purposes. The coverage
period can be set to be commensurate with the nature of the risk, for example, for a
trip, during a tropical storm season or even for multi-years. The coverages are written
on the “named risks only” basis, thus leaving little room for disputes regarding covered
risks in parametric insurance.

• Reduction in informational frictions. Because the payment in parametric insurance

is made based on the objective occurrence of the pre-defined loss event, the insurer
does not need to monitor its insureds throughout the coverage period. The payment is
pre-determined and the insured has no economic incentives to change the loss outcome.
Instead, a reasonable insured should engage in risk prevention and mitigation activities
to reduce the total loss caused by the event. This payment structure thus reduces the
insurer’s exposure to the problem of moral hazard. The risk of insurance fraud can
also be effectively controlled down to an insignificant level because the loss event is
verified by a third party independent of the influence by the insurer and the insured.

We can still observe moral hazard, albeit at a much lower degree than in comparable
indemnity insurance, when the parametric trigger is built on the difference between
each insured’s production revenue and the average revenue of the insured area for each
year, as observed in simple aggregate loss index agriculture and livestock insurance.
Similar problems can be observed if the insured can monitor the inverse relationship
between the product price and the production quantity. Indemnity insurance can
control the insured’s behavior by imposing risk-sharing deductible or loss-sharing coin-
surance requirements. However, such requirements have no effect when the payment
is pre-determined. The presence of this possibility explains the reason why paramet-
ric insurers move away from the use of a trigger which is built on the intertemporal
variations in the insured region over coverage periods (aggregate loss index). For pure

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 parametric and parametric index insurance, problems of moral hazard can be effectively
controlled.

• Prompt settlement of claims. The payments in parametric insurance can be made

promptly once a covered event has been verified. In fact, this “contract certainty”
with respect to the claim payment can make parametric insurance attractive to a broad
range of insureds - including corporate clients for managing risks at the enterprise level
- provided that the insurer can effectively manage the basis risk (to be discussed later).
It helps individual insureds, particularly the poor because the prompt payments would
prevent them from falling further into the vicious cycle of poverty.4

• Low transaction and operating costs. Generally, parametric insurance does not require
an assessment of each insured’s risk profile or investigation of losses. The premium rates
are set based on the analysis of “objective” data and the rates tend to move linearly to
the coverage amount each insured selects. The trigger is set based on the factors that
are beyond the control of the insured. Accordingly, parametric insurance writers face
almost nil problems of adverse selection and can effectively lower their underwriting
costs under usual circumstances. In the case of covering potential revenue losses (for
example, a decrease in occupancy rates or a rise in loan default rates) or increases in
operating capital (for example, a rise in the emergency budget need) for large clients,
risk aggregators and government agencies, the insurer needs to conduct a reasonable
analysis of the insured’s financial and operational activities for trigger and coverage
limit setting.

Separately, parametric insurers benefit from almost no claim investigation costs because
claims are paid automatically once the coverage has been triggered. Due to a regulatory
compliance concern, however, insurers need to collect evidence that the claimholder has
an insurable interest at the time of loss.
4
For example, in northern Ghana, Karlan et al. (2014) find from conducting several experiments with
farmers (2008-2011; 502 households) that the consumption of index insurance rose strongly in subsequent
years when they had received a payment, observed other insureds in the network receiving payments or
recently experienced a catastrophic event in the area.

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 As highlighted in Table 1, some concerns exist that require close attention before para-
metric insurance becomes widely available. We elaborate on them as follows.

• Front-end cost and policy transferability. In principle, every parametric insurance pol-
icy is unique and custom-designed based on a specific set of risk factors surrounding
each insured or a group of insureds. Parametric insurance is heavily loss data driven.
The cost of building infrastructure for data collection and other operational costs can
be substantial for the design and introduction of parametric insurance. Data becomes
more widely available and reliable. However, it is not necessarily available free of
charges. The more precision needed in the data, spatially and inter-temporarily, the
higher cost of that data the insurer bears. The cost can be significant especially when
the insurer needs to install the infrastructure for data collection. In weather-indexed
parametric insurance, for example, an insurer may need to subscribe to weather data
services and install weather stations to improve data quality.

Parametric insurance is context sensitive as well. In typical parametric insurance cov-

erages, the parameter is set based on the statistical analysis of a specific loss event
(or a set of loss events), of a specific region and of a specific risk (or a pool of rea-
sonably homogeneous risks). However, the loss can be affected by the proximity of
the insured location to a nearby body of water (for example, as in property coverage),
soil agrometeorological conditions (as in agricultural insurance) or economic conditions
(as in revenue protection insurance). If the insurer defines its parameter based on a
narrowly defined geographical area, the cost of insurance could be quite high and its
scalability to other areas limited (World Bank, 2011). The insurer must thus evaluate
its investment in infrastructure as well as the cost for product design carefully along
with its analysis of the expected demand for insurance.

We observe improvement in data sources and insurers’ pricing and modeling techniques
as well as advances in information technology. As a result, the front-end cost burden
continues to decrease while parametric insurance becomes increasingly portable. For
example, a parametric insurer may make a reasonable adjustment of client-specific risk

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 factors to transport a coverage developed for, for example, a resort operator along
a river, to other clients in the same area that need similar insurance protection, for
example, river cruise operators. The insurer may consider applying its current modeling
techniques to new clients in other regions, such as flight delay coverages for airline
carriers or passengers. What matters are the availability of reliable data and the
insurer’s expertise and capital capacity. Commercially viable weather index-based
insurance products need to allow scalability (that is, being able to replicate the same
modeling method) while maintaining flexibility (that is, being able to adjust the model
to reflect client or industry-specific factors).

• Understanding the value of parametric insurance. The importance of consumer ed-

ucation should never be underestimated in both inclusive and commercial provision
of parametric insurance. Some buyers of a well-designed parametric insurance prod-
uct may exhibit dissatisfaction simply because they do not receive a payment or the
payment is below their expectation. As compared to other indemnity principle-based
insurance, parametric insurance offers limited room for claim negotiation because the
claim decision is not based on individual losses. Consumer dissatisfaction with para-
metric insurance can affect their perception about the value of other products the
insurer offers. Therefore, consumer education is pivotal to the success of paramet-
ric insurance. Insurers must make sure that consumers understand the design of the
product and have realistic expectations of the benefits and the associated costs of
parametric insurance. We suggest that insurers reflect on the following two kinds of
differences in building a sustainable parametric insurance culture: a financial literacy
gap between the consumers who have prior insurance experience and others who dont;
and a financial literacy gap between individuals and risk aggregators.5
5
The study by Gaurav et al. (2011) find that financial literacy education positively affects the adoption
of rainfall index insurance, increasing the consumption rate from 8% to 16%. Dercon et al. (2013) measure
the effect of client education on rainfall index insurance consumption by groups of farmers in Ethiopia and
found that the consumption rate rose significantly among the members whose leaders had received training
about the risk sharing benefits of insurance as compared to the members who had been educated about
the benefits of insurance to individuals. Their finding indicates that the focus of education, not simply the
delivery of education, can directly affect insurance consumption at the group level.

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• Basis risk. Managing basis risk is one of the key factors for the success of parametric
insurance operations. Basis risk exists in all forms of insurance. In indemnity insurance,
basis risk can be interpreted as the difference between the loss incurred by the insured
and the amount of indemnification from the insurance contract. The design of the
insurance contract (for example, deductible, coinsurance and policy limits) can cause
the difference. The basis risk in this regard is not of much concern because the difference
is predictable and its likelihood is already communicated to the insured at policy
inception. What could become concerning is when the difference is caused by the
insurer’s error in risk underwriting and claim assessment. A prudent insurer should be
able to manage its underwriting and claim assessment risk, thus being able to control
its basis risk.

In parametric insurance, basis risk is about the deviations of the actual claim payment
- positively and negatively alike - from the expected payment. However, close exami-
nation shows that the basis risk in parametric insurance is about the variance of the
distribution of the insured’s losses given a specific value of the index (Skees, c.2012).
The risk is about the sensitivity of the insured to the systemic index that affects the
payment availability after each loss event. In this paper, we define basis risk as “the
difference between the payment based on the simple parameter (or the loss model) and
the actual loss of the insured”. And there are two types of basis risk - positive and
negative basis risk.

The “positive basis risk” refers to the differences arising when the insurer pays claims
to the insureds that are not affected by a loss event or the payment is more than the
actual loss. These cases are marked in blue diamonds in Figure 2. Positive basis risk
is about underpricing risks or charging insufficient premium rates retrospectively. It
can affect the insurer’s insolvency risk. Effective management of positive basis risk
requires the insurer to have a comprehensive understanding of the loss exposures of
the insureds and to select the most suitable parameter to fit the exposures (NAIC,
2018).

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The other is “negative basis risk”, referring to the differences arising when the insurer
fails to pay claims to the insureds that have experienced a financial loss from a covered
event or the payment is less than the actual loss. These cases are marked in red circles
in Figure 2. Negative basis risk is about the underpayment of claims to those insureds
that have paid premiums. Negative basis risk can be a factor that increases customer
dissatisfaction, decrease policy renewal rates, if not both. A rise of negative basis
risk can also signal a failure of an inclusive insurance program for the reduction of
protection gaps. Negative basis risk connotes reputational risk of the insurer. The
World Bank (2011) reports that private insurers’ hesitation in participating or scaling-
up their participation in the parametric insurance market can be explained in part
by the possibility that negative basis risk causes harm to their reputation in sales of
other products in the local market. Therefore, insurance companies need to evaluate
the benefits and costs of adding parametric insurance to their product portfolios.

Figure 2: Positive and Negative Basis Risk.

Loss Amount

Insurance Limit Payment Line

Negative Basis Risk Area

Positive Basis Risk Area

Parameter
Attachment Exhaustion

Loss (under-paid) Loss and no loss (over-paid) Loss (retained by insured)

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 Both the positive and negative aspects of basis risk need close attention because the
former can increase the insolvency risk of the insurer and the latter affects consumer
satisfaction and policy renewal. A number of factors affect basis risk in parametric
insurance. For one, imperfection of the model and insufficient data quality gives rise to
basis risk; for another, idiosyncratic factors such as each insured’s net wealth, sources
of income and risk attitude (that can affect their perceived value of insurance or their
sensitivity to loss events), also give rise to basis risk. Idiosyncratic risk more likely
results in negative basis risk. When idiosyncratic risk is high, the number of unsatisfied
insureds may rise. If the insurer fails to manage this idiosyncratic risk, the policy may
even become a “costly, risk-increasing gamble” rather than a risk-reducing product
(Jensen et al., 2016). On the other hand, a failure in managing positive basis risk
literally means the insurer is experiencing premium inadequacy because the insurer is
making payments for the cases it did not factor in risk pricing. The failure would force
the insurer to increase the size of and volatility in loss reserving. Consequently, the
insurer will end up needing more capital cushion to absorb the shocks arising from the
combined effects of pricing inadequacy, loss reserve volatility and business risk.

• Regulatory compliance. The parametric insurance market, particularly for the private
sector, is still at its infancy and the products are accepted only in a limited number of
countries and for selected risks. Regulatory compliance, especially when it comes to
insurable interest, will be discussed in more detail in the next section.

4 Legal Principle and Insurable Interest

This section examines the matters related to the regulation of parametric insurance. Insur-
ance can be defined as a contract by which, in exchange for a premium, the insurer promises
to provide the insured with financial protection against loss, damage or liability arising from
a covered event.6 This kind of a simple definition is likely what we find in typical insurance
6
Insurance acts may use the term “indemnification” referring to the insurer’s obligation for claim pay-
ments. However, use of the term reflects more of the tradition in insurance practices than of a restriction on

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acts, for example, as in the study of European insurance contract laws (Basedow et al.,
2016). In fact, an exhaustive definition of insurance is rarely found in insurance acts in part
because such a definition could work as a constraint to the dynamicity of insurance business,
and the authorities do not need to assume the risk of inadvertently excluding contracts that
should be subject to insurance regulation (Birds and Hird, 2004). The courts can affect the
definition of insurance and the scope of the insurance business.
Governments generally do not use a precise definition of insurance but a collection of
principles to evaluate whether a contract is subject to insurance regulation. For example,
insurance contracts in Singapore are required to embed a few common law principles includ-
ing but not limited to: (1) the risk must be a pure risk; (2) the event must be one that
involves some element of uncertainty; and (3) the insured must have an insurable interest in
the subject matter of the contract (MAS, 2009). Further, insurance acts tend to use a broad
classification of insurance coverages. In nonlife insurance, they are generally indemnity in-
surance policies (also termed as open policies) in which the claim amount is calculated at
the time of loss and valued policies (also terms as fixed-sum policies) in which the insurer’s
obligation is pre-determined at policy inception. Indemnity insurance is, of course, based on
the indemnity principle such that the insured is restored to an approximate financial position
prior to the loss event.
Another key principle in insurance regulation involves the elements that constitute in-
surable interest. The principle applies such that the insured must suffer from an economic
loss - whether it involves a reduction of current wealth or loss of future income - if a covered
event occurs.7 Insurance acts, albeit not all, define the nature of insurable interest and the
time when the interest is required. In the UK, for example, the Marine Insurance Act 1906
the permitted methods for claim payments.
7
The English and Scottish Law Commissions, referring to the 1906 Marine Insurance Act, note that “for
a contract of insurance to be valid, the person taking out the insurance must stand to gain a benefit from
the preservation of the subject matter of the insuranceand to suffer a disadvantage should it be lost or
damaged” (The UK Law Commision, 2018). Besides, the English and Wales law position (that is, at the
time of loss but not necessarily at policy inception) seems to be different from the Scots law position (that
is, at policy inception) for non-marine insurance contracts. Separately, the Gambling Act of 2005 removes
the requirement of insurable interest in general insurance in dire contradiction to the provision in the still
enforced laws and regulations in the UK insurance market.

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and Scots common law apply such that a nonlife insurance contract without insurable inter-
est is void.8 In the state of Florida, which permits parametric insurance against hurricane
risk, the law for property insurance defines “insurable interest” as “any actual, lawful, and
substantial economic interest in the safety or preservation of the subject of the insurance
free from loss, destruction, or pecuniary damage or impairmentas at the time of loss.” In
California, sections of the state insurance code define insurable interest in a way that ap-
parently permits parametric insurance against earthquake risk. Below we offer a generalized
observation of the application of the insurable interest principle to indemnity, valued policy
and parametric insurance coverages.
Insurable Interest in Indemnity Insurance. Indemnity insurance complies well with
the principle of insurable interest regulation because it is built on a close relationship between
the premium and the loss payment even at the risk pool level.9 Indemnity insurance writers
generally verify the presence of insurable interest from conducting claim investigations and,
with a proof of covered loss, initiate the claim indemnification process for each case. Two
methods are commonly used for this purpose. Under the actual cash value method, the
claim payment reflects the covered amount of loss in liability claims or a proxy value of the
damages in the economic community at the time of loss in property insurance.
Under the replacement cost method that applies to property coverages, the insurer does
not factor in depreciation for restoring damaged property, thereby allowing the possibility of
over-indemnification. This contractually designed over-indemnification is not only incidental
but also beyond the control of the insured, thus being different from gains in speculative risk
activities.10 In fact, no laws are known that prescribe that the insurance claim shall not
exceed the actual loss.
Similarly, the coverage for loss of income and extra expenses in business interruption
8
The UK and Scottish Law Commissions continue to examine whether or how to modify the application
of insurable interest to life insurance.
9
The relationship would become weak when the insurer fails to manage the pool with reasonably homoge-
nous and independent risks (that is, an adverse selection problem) or when the insured could affect the loss
outcome (that is, a moral hazard problem). Accordingly, prudence in underwriting and claims management
is critical for the success of indemnity insurance programs.
10
In practice, the premium rates for replacement cost-based policies are adjusted higher to cover the loss
exposure in excess of the actual cash value based loss estimate.

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insurance is acceptable as insurance because this consequential loss is unexpected and beyond
the control of the insured, thus being different from the loss of income as a direct result of
a business decision.
Insurable Interest in Valued Policy Insurance. In the valued policy segment of the
business, insurers need to check the presence of insurable interest at policy inception and
proof of a loss at the time of loss. The claim payment amount is pre-determined at policy
inception and there is room for the claim payment exceeding or falling short of the actual
loss. Under usual circumstances, insureds are unable to affect claim payment amounts and
the payment deviations from actual losses are incidental. Accordingly, regulatory authorities
generally consider this type of policies in compliance with the definition of insurance and
the insurable interest principle.
Insurable Interest in Parametric Insurance. It is not fully settled in a number
of jurisdictions whether parametric insurance complies with the local principle of insurable
interest. We examine this matter from two angles. First, finding and recording a proof of loss
can be straightforward in the parametric insurance policies customized for single, large risks.
In the policies designed for small risks, the design of parametric insurance should be built
on the statistical demonstration that a correlation exists between covered loss events and
the trigger and that the trigger is a statistically acceptable proxy of insureds’ loss exposures.
Hence, we can also demonstrate that insureds have an insurable interest at the time of loss.
Second, it would not be of much regulatory concern whether the claim payments are greater
or less than actual losses. No laws would state that the insurance claim shall not exceed the
actual loss. Reasonable deviations from actual losses are permitted as found in indemnity
and valued policy insurance cases.
As few governments are known to have introduced a law or regulation specific to paramet-
ric insurance (NAIC, 2018), insurance authorities are likely to regulate parametric insurance
with the same measures they use for nonlife insurance companies and markets.11 Even in
countries with a specific law, insurers should not expect any material differences in the
11
Regulatory risk refers to the risk associated with the regulatory structure in the jurisdiction of the
insurer’s operation.

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frameworks for financial or market conduct regulation.
Laws are clear, however, in that insurance is for protection against economic loss. Para-
metric insurers thus need to exercise diligently to manage cases of claim payments for insureds
without any covered loss. In selected policies where the data specific to each insured triggers
the payment (for example, flight delays), the likelihood of such payments is low. In selected
other policies (for example, coverages against natural catastrophes or climate changes), this
likelihood could rise. We suggest the following:

• Parametric insurance must be structured to function only with risks resulting in loss
of the insured (whether it being a loss of assets, a reduction in revenues or a rise in
expenses) and that any claim payment in excess of the actual loss must be accidental
and contingent to the occurrence of a covered event that is beyond the control of the
insured (and the insurer).

• Parametric insurers keep a clear record of verification of losses from all insureds that
have received a claim payment. The verification is not anything costly with the ad-
vances of information technology and smart contract techniques. Neither would it
include actual assessment of claims unless warranted.12 Instead, the insurer builds ev-
idence, retrospectively where possible, that any deviations of claims paid from actual
losses are in line with what is “reasonably expected” in the model.13 Smart contract
techniques increasingly make possible a collection of this type of record promptly and
cost effectively.

• Parametric insurers may set the range for claim payments close to the modeled loss
area that, ceteris paribus, gives them statistical confidence not only in proving the
12
For example, Argentina seems to hold a view that no changes in the insurance law are required to
admit index-based agricultural insurance in which the index is set based on a high correlation between
climate phenomenon and crop productivity (Mercosur Group, 2016). There are two conflicting sections
in the Insurance Code in Brazil. One section prescribes that the guarantee in insurance is not for “the
compensation indemnity of future damage but the legitimate interest of the insured,” while another section
affirms that the insured must suffer from a covered loss as a pre-requisite for any indemnification (AIDA
Climate & Catastrophic Events Working Party, 2017).
13
It is critical to note that in indemnity and valued policy-based insurance, the insurer must demonstrate
a statistically significant relationship between premiums and loss payments at least “at the risk pool level.”

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 correlation but also in operational and capital solvency management.

5 The Parametric Insurance Market

The classification of parametric insurance to micro, meso and macro-type is useful for the
identification of the areas that private insurance and reinsurance companies wish to operate.
The discussion is based also on the type of risk financiers so that we can generate a better
understanding about the breadth of potential clients as well as the types of loss events that
can be covered by parametric insurance. We depict these aspects using the diagram in
Figure 3.
Access to the reinsurance market is critical for the success of parametric insurance, even
at the micro-insurance level. Private reinsurance companies can play an important role in
all layers of parametric insurance. Also, regulators’ concerns about parametric insurance
products would vary depending on the depth of involvement of international reinsurers. It is
speculated that they would become less concerned about the technical expertise and capital
capacity of local insurers as their cession rates to the international reinsurance market become
significant (Carpenter, 2018).

5.1 Parametric Insurance for Micro-Risks

The prefix “micro” is used for two seemingly related but independent insurance programs.
For one, we use it for micro-insurance designed for the low-income population with no or
limited access to the traditional insurance market. In this primarily inclusive insurance
program, the coverages are simple and for critical risk protection only, the premiums are
set low, and the insurance limits are commensurately low. Both indemnity and parametric
micro-insurance products are available and normally on a group insurance basis.
The oldest form of parametric insurance is observed in the micro-insurance market. Like
other parametric insurance coverages, parametric micro-insurance is context-sensitive. It of-
ten requires a large initial investment for infrastructure development for product distribution

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and consumer education. As a result, public and donor-supported institutions have led the
supply of parametric micro-insurance products. The participation of the private insurance
sector is rising in this market segment and a number of insurance companies offer their own
parametric insurance programs. We show this segment of the market at the left-bottom
corner of Figure 3 and offer a summary of selected insurance programs here.

Figure 3: Risks, Risk Underwriters and Parametric Insurance.

Parametric Insurance Insurance Linked Securitization

Risks

Macro-risks Society/Economy Protection

• National governments Public asset protection & emergency revenues
Victims aid
• Intergovernmental agencies Infrastructure repair
• Regional pools

Meso-risks Protection Gap Reduction

Revenue Protection
• Government agencies Public assets, emergency revenues & victims aid
Revenue protection
Loan default, lending cost
• Utilities & communications (Cost subsidization likely)
entities Asset Protection
• Large corporations Property, business interruption, loss of income
• Lending institutions and MFIs Third-party liability
Other under/uninsured risks
• Other risk aggregators

Micro-risks Protection Gap Reduction

• Individuals and small businesses Asset and Revenue Protection
Output & revenue protection
First-party risks
• Agriculture, agua-culture and (Cost subsidization likely)
other industries
Risk Underwriters

Private/Commercial Insurance

Public/Donor-supported Insurance Reinsurance/Capital Market

• Brazil, Chile, Peru and Uruguay are known to have or are examining government-led
parametric agricultural insurance products (Mercosur Group, 2016; AIDA Climate &
Catastrophic Events Working Party, 2018). In Brazil, ArgoBrasil is in partnership with
several insurance and reinsurance companies to offer an aggregate loss index insurance
program. Qualified low-income farmers may voluntarily participate in the program
that comes with heavy premium subsidies by the government. The program uses the
deviation of each insured’s yield from the average regional yield as a basis for claim

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 payments.

• In Mexico, the government offers a parametric index insurance program against drought
risk. It is designed specifically for livestock farmers that would incur additional feed-
ing costs to maintain animals’ minimum weight. The loss model uses the satellite
image-based Vegetation Index data from the US National Oceanic Aerospace Agency
(NOAA) to measure the biomass in the insured area. The coverage is triggered when
the biomass drops below the policy-set threshold and the payment is made immedi-
ately. Agroasemex, a state-owned reinsurance company, and international reinsurers
participate in the program.

• In India, the government introduced the Weather-Based Crop Insurance Scheme (WB-
CIS) in 2004 as an inclusive insurance program to protect eligible poor farmers against
weather-related risks such as rainfall, temperature, frost, humidity, hailstorm or a
combination of the risks (Cole and Xiong, 2017). This aggregate loss index insurance
program sets the trigger based on the loss analysis of a relatively homogeneous group of
insureds in each of the reference unit area (RUA). Qualified public and private nonlife
insurance companies in India supply the coverages.

• In China, the World Food Program (WFP), the International Fund for Agricultural
Development (IFAD) and the Ministry of Agriculture pilot tested parametric insurance
against the risk of heatwaves and droughts for about 500 households in 2008. The test
results indicate that there were issues related to the underdevelopment of weather data
infrastructure, a weak interest of private insurance companies and a lack of consumer
understanding. There was an idiosyncratic risk as well: agriculture prices are very low
in China and farmers often have external income sources, thus not having a strong
incentive to protect their agriculture assets (UN ESCAP, 2015).

• In Thailand, a weather index-based insurance program was pilot tested for a group of
farmers on a voluntary participation basis. It covered drought risk. The insurer used
the data from the Bank for Agriculture and Agricultural Co-operatives of Thailand to

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 determine the three protection periods (early drought, drought, and severe drought).
The claim payments varied according to the month of loss event occurrence. The UN
ESCAP (2015) reports that the test was unsuccessful due likely to the lack of consumer
awareness and knowledge about the product.

The term “micro” is also used with reference to private market insurance for individuals
and small businesses. They consume a wide variety of insurance coverages. As alluded to
earlier, however, there are gaps between their protection needs and insurance coverages in
the conventional market. Parametric insurance can be a solution to the problem of these
gaps. This segment of the market is at the middle-bottom section of Figure 3. Below is a
summary of selected insurance programs in this segment.

• Parametric insurance against earthquake, tsunami and other earth movement risk can
be made available. Conceptually, a policy can be designed where the trigger is set
based on the shake intensity analysis of the covered area. In Japan, for example,
the Earthquake Insurance System provides an indemnity insurance coverage - as an
endorsement to fire insurance - for household residents against damages resulting from
earthquakes, volcanic eruptions or tsunamis. Hattori (2018) expects that this risk
could be underwritten based on a parametric insurance model in the future. Under
the “Society 5.0” (super smart society) concept, for example, the Real-time Earthquake
and Disaster Information Consortium can generate data from about 1,700 observation
networks around the country for estimation of the risk at the village level or per 250
square meters.

• In the US, a Lloyd’s syndicate underwrites the risks submitted by JumpStart, its
surplus line broker. JumpStart sells parametric insurance coverages against earthquake
risk for individuals - property owners and tenants - in California. The policy trigger is
not based on the Richter Magnitude but on the “severe shaking” with a Peak Ground
Velocity (PGV) of at least 30 centimeters per second, as determined on the basis of
data from the USGS shakemap within 24 hours after an earthquake event. At the onset

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 of a covered event, JumpStart text-messages to all insureds in the affected area. It
requires an affirmative response from each of the affected insureds before it transmits
the claim payment to the insureds bank account. It limits the payment to $10,000 per
occurrence and $20,000 per annual coverage period. JumpStart does not require its
insureds to have a separate homeowner’s or earthquake coverage.

The JumpStart insurance program carries a few features. First, it is a first-dollar

insurance coverage. Second, it is designed to cover the extra expenses that the residents
in the insured property would incur. Accordingly, the insurer does not only allow
family members to stack coverages but also let other residents in the insured property
to purchase the policy individually. Third, its policy is partially smart contract-based.
Finally, the practice of requiring an affirmative response from each affected insured
invokes the local requirement of the presence of insurable interest for a contact to be
subject to insurance regulation. The next section in this paper illustrates a parametric
insurance case involving the earthquake risk in California.

• Also in the US, Topa Insurance Company offers a parametric index insurance coverage
to protect homeowners in Florida against “named” hurricane risks. Typical policy lim-
its range from $10,000 to $15,000 for the insureds who also have an indemnity-based
hurricane insurance contract and up to $60,000 for other homeowners. It uses three
factors to set the coverage trigger - the hurricane strength, the shortest distance be-
tween the hurricane track and the insured property, and the loss amount. At the onset
of a covered event, the insurer notifies electronically (for example, via text messages)
all potentially eligible insureds. All insureds with an incurred loss are required to at-
test the incident and the amount of loss. The insurer then initiates the payment of
the claim, subject to the balance of the annual policy limit, within 72 hours of receipt
of the attestation; the insureds have 45 days from then to submit online their proof of
loss.

• In China, three domestic insurers - PICC, Ping An, and CPIC - partner with Swiss Re
to offer a parametric insurance policy against typhoon and excess rainfall risks. The

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 coverage is limited to RMB 20,000 per address for individuals and RMB 500,000 per
address for businesses. The trigger for payout depends on a typhoon’s path and wind
speed. It allows the insured to check if payout is triggered where her property is using a
smartphone. All affected insureds can file claims online. The insurance program verifies
all submitted claims automatically and wire transfer the claim payments within three
days.

• Taiwan Marine & Fire Insurance, in partnership with Swiss Re, provides onshore fish
farmers with a pure parametric insurance coverage against the risk of overflowing of
onshore fisheries and escape of the fishes. The trigger is simple and based on the
national weather data. The insurer pays claims automatically once a rainfall has
exceeded 480mm in two consecutive days. This case demonstrates that parametric
insurance can be extended to cover risks in aquafarming.

• Parametric insurance can be extended to cover man-made risks, such as flight delays
and event cancellation. In fact, a coverage can be designed to cover micro-risk indi-
viduals (such as passengers) and separately to cover meso-risk corporations (such as
airlines) that we discuss in the next section. For example, Fizzy - a parametric in-
surance offered by AXA - is available to individual passengers who wish a protection
against the flight-delay risk. Via embedding the insurance program to official flight
delay information portals, the insurer can automatically detect all eligible delays of
two hours or longer and notify the affected insureds accordingly. It covers all causes
of delays - for example, weather, strikes, mechanical issues and airport system failures
- but does not cover flight cancellations. Claims can be paid immediately upon the
passengers’ arrival at the destination, or within a reasonable period. In this type of
policy, the fact that the insured passenger has purchased a ticket and was onboard the
plane which was delayed indicates that there was an insurable interest at the time of
loss. This coverage is currently available to residents in selected countries in Europe.
See the discussion in the next section about a similar coverage designed for airline
companies as the buyers of insurance on behalf of their passengers.

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 • In Singapore, a subsidiary of MetLife distributes a smart parametric insurance con-
tract through participating clinics. The policy offers two possible payouts: if a pregnant
woman is diagnosed of gestational diabetes, then she receives an automatic payment of
$500; or if a pregnant woman is diagnosed of one of the listed gestational diabetes re-
lated complications, then she receives an automatic payment of $2,000. This insurance
is built on access to consumer health data with consumer consent. There are some
minimum eligibility criteria (for example, pre-existing health condition exclusions).

5.2 Parametric Insurance for Meso-Risks

This type of parametric insurance is designed for the protection of local governments, banks,
microfinance institutions, large corporations and other “risk aggregators”, of which loss ex-
posure alone is sufficiently large enough to command a custom-made insurance policy. These
large entities and risk aggregators consume a wide array of indemnity insurance coverages
for the protection of their assets against weather and non-weather related causes of loss.
They also tend to add a supplemental coverage for the loss of income and additional oper-
ating expenses. However, the standard business interruption and extra expense coverage is
indirect and the insured must have suffered from direct damages to its insured property by
a covered cause of loss (for example, fire damages to an insured property).
Parametric index insurance can offer these “risk aggregators” a solution. For example,
local governments would need emergency funds to repair and rebuild infrastructure or to offer
financial aid to the victims of a disaster in their jurisdictions, and parametric insurance can
offer them an immediate capital relief. Banks and microfinance institutions may experience
a rise in the loan default rate as a result of a loss event affecting their business areas, and
parametric insurance can be used to fill the gap. Large resorts would need to protect not
only their properties but also a reduction of occupancy rates, and parametric insurance can
be designed to meet their insurance needs.
Typical meso-risk programs involve some consideration of client-specific and industry-
specific factors - for example, property structure, financial analysis and seasonal fluctuations

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of revenue - for determination of the trigger and policy limits. Some meso-risk programs are
available with public assistance, particularly those programs designed to protect government
agencies. Other programs are purely private-sector initiated. As depicted in Figure 3, we find
that private insurance and reinsurance companies can play a pivotal role in this meso-layer
of insurance. We highlight selected programs in this market segment.

• Through its Global Parametrics and in collaboration with partner companies, AXA
offers parametric index insurance coverages against climate risks to businesses in need
of financial protection from delays in construction, a rise in operating costs or a fall in
revenues.

• SCOR offers parametric insurance solutions to corporations and public entities against
natural hazards and weather-related risks. The coverages can be custom-made to the
specific needs for financial protection by the client entity, for example: an impact
on yield (agriculture), a production capacity issue (energy), work interruption, ex-
tra costs and penalties due to delays (construction), cancellations (sports, events and
transportation), decreases in sales (retail) and costs for snow removal (government).
The coverage period can be annual or span several years. SCOR may offer it as a
stand-alone or in combination with indemnity insurance coverages (Foucart, 2018).

• In Spain and France, Meteo Protect, a Lloyd’s coverholder, provides parametric index
insurance that protects agribusinesses - for example, olive growers in Spain and wineries
in France - against the weather-caused impact on their financial performances. It allows
the insureds to select their policy specifications, including geolocation, coverage period
and weather parameter. Depending on what weather parameter significantly affects
the insureds’ revenue, the parametric trigger will be set accordingly. For example, if it
is found that temperature anomalies negatively affect sales, then the payment trigger
will be based on temperature anomaly.

• Swiss Re offers STORM and QUAKE. The triggers in both products are defined to the
postal code level and are set based on the wind speed for windstorm and the seismic

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 measure for earthquake, respectively. Payments are likely available within 30 days from
the event date. For QUAKE, the insurer assumes that the earthquake intensity and
the downward economic cycle could increase the bankruptcy risk of the corporations
in the affected area. Accordingly, client corporations may consider an earthquake
magnitude-based parametric insurance coverage for their business areas with a high
probability of earthquake occurrence and an earthquake intensity-based parametric
insurance coverage to protect their assets nationwide (Swiss Re, 2018a).

• Swiss Re’s Flight Delay Compensation insurance covers private passenger airlines
against the risk of flight delays. Through a real-time data capturing system, all covered
events are automatically detected and the resulting claim payments are available on
delayed landing. The insured may add an additional coverage that protects the airlines
against the loss of revenues or additional expenses they would incur due to an extended
delay in scheduled services. These products deal with the same risk we covered in the
micro-risk cases. The difference is that the buyer is the airline corporation in this case
whereas the buyer is individual passengers in the micro-insurance case.

• In Hong Kong, Swiss Re offers a parametric index insurance policy named Insur8 for
corporations that would incur revenue losses due to a mandatory closure of their op-
erations following a level 8+ typhoon warnings issued by the Hong Kong Observatory.
This product is unique in that the claim is triggered by a warning. The insurer may
make sure that the insured corporations have an insurable interest based on the finan-
cial statement information they submit at policy inception or at the beginning of the
storm season, whichever is the more appropriate for a regulatory compliance purpose.

• Private insurers may participate in the meso-risk insurance programs designed for
public entities. In the Philippines, the national government proposed the Philippine
Disaster Insurance Pool Project (PCDIP) in June 2018 to protect local governments
against natural hazards (Asian Development Bank, 2018). The administrator, Pacific
Catastrophe Risk Insurance Company, uses the Philippines Catastrophe Risk Model

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 for model development and premium rate calculation. Only qualified local governments
may participate in the program and the use of the payment is limited for post-disaster
activities relating to government infrastructure, facility restoration and delivery of basic
public services (Philippines Department of Finance, 2017). This project is supported
by the World Bank and leaves room for cessions of the pooled risk to the reinsurance
market.

• MiCRO, a World Bank supported program, offered a program in Haiti that covered
a major microfinance institution (MFI) with a weather-and-seismic index-based para-
metric layer of insurance, thus extending the insurance benefits indirectly to the MFI’s
clients. Another example from a risk bearer’s perspective is R-FONDEN (El Fondo Na-
cional para el Desarrollo Nacional) that the Mexican government has developed as part
of its disaster risk management program. This probabilistic catastrophe risk assess-
ment platform factors in multiple inputs (for example, public assets and infrastructure)
to produce annual expected loss and probable maximum loss and other output metrics
(OECD, 2012).

• In the US state of Alabama, the State Insurance Fund purchased a pure parametric
insurance policy from Swiss Re. In this multi-year policy (July 2010 - July 2013),
the coverage would be triggered when the wind speed of a hurricane eye exceeds the
threshold and the payment - the full insured amount for a Category 5 hurricane and a
half of the full amount for a Category 3 or 4 hurricane - would be made in about two
weeks (Pagniez, 2016).

• Attempts have been made in the US state of Hawaii to introduce a parametric insurance
program for the state government. When enacted, the government would have access to
an additional fund for emergency response cost, lost tax revenues or other appropriate
purposes.

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5.3 Parametric Insurance for Macro-Risks

This type of parametric insurance is designed for national governments, alone or partici-
pating in a pool, for the protection of the economic community and citizens against one or
more catastrophes. Governments often use a wide range of risk financing tools, including in-
demnity insurance policies, insurance-linked securitization and other alternative risk transfer
arrangements, and parametric insurance.
Parametric insurance programs in this segment are commonly for national governments to
deal with the increase in their budgets for infrastructure repairs, maintenance of government
functions and disaster-relief activities. Accordingly, typical parametric macro-risk policies
contain a provision governing the area and scope for the use of the claim payment and
another provision detailing the qualification criteria for candidate governments. Private
insurance and reinsurance companies seem to be active in offering technical assistance and
risk underwriting. We highlight selected programs here.

• The Caribbean Catastrophe Risk Insurance Facility (CCRIF) is the worlds first risk
pool to provide parametric insurance coverages against natural catastrophic risks (that
is, hurricanes, earthquakes and rainfall). The coverages are available to 19 Caribbean
governments plus 2 Central American governments. The program limits the use of
the claim payment to financing member governments’ disaster response expenses or
maintaining their basic government functions after a covered event. All claims were
made with 14 days from the event date (CCRIF, 2017).

The program comprises three parts for risk sharing. The bottom layer (the event
likelihood up to 1 in 10 to 20 years) represents the part of the risk each member country
retains using its own reserves or line of credit. There is a loss-sharing arrangement
above this attachment point and up to the limit of insurance (or up to 1 in 75 to
200 years). The CCRIF may arrange reinsurance to build its claim payment capacity,
which is the area that private insurance companies play an important role. Lloyd’s
has been providing reinsurance coverages in this layer (CCRIF, 2017). The CCRIF
makes available two endorsements to the insurance program. The Reinstatement of

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 Sum Insured Cover reinstates the initial limit of insurance once it has been exhausted.
The Aggregate Deductible Cover (ADC) provides a minimum payment for the events
with losses below the attachment point. The ADC is added to reduce the negative basis
risk or the design risk, that is, the probability of a missed payment when a member
government has sustained a covered loss but the model did not trigger the coverage.

• The African Risk Capacity (ARC), a sovereign insurance pool managed by its sub-
sidiary, ARC Insurance Ltd., provides member governments with parametric index
insurance coverages against drought risk and other extreme weather risks in the fu-
ture (rainfall, flood and tropical storms). Established in 2012, the pool requires each
country to submit a contingency plan regarding the use of the claim payment as a
pre-condition for pool participation. The member country may customize and define
its own parameters. The ARC offers coverages of up to $30 million per season for
drought with a minimum attachment point of a 1-in-5-year event.

Its loss model, African RiskView, uses the Water Requirements Satisfaction Index
(developed by the UN Food and Agricultural Organization) to estimate the impact
of a rainfall shortage on crop yields and the availability of pasture. This drought
index is then overlaid on population vulnerability data to estimate draught-affected
populations and the government response costs. The ARC reports that the population
vulnerability is measured using a combination of the resiliency factor (the distance
of a household income from the national poverty line) and the exposure factor (the
percentage of household income at risk to drought) and that the government response
cost is an estimate based on the country’s response modalities and contingency plan
for ARC participation.

• The Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI) offers
parametric insurance coverages to member countries (Tonga, Samoa, Cook Islands,
Vanuatu and Martial Islands) against earthquake-tsunami and tropical cyclone risks. It
is estimated to have an underwriting capacity of $45 million, inclusive of the support by
four private reinsurance companies (Hanover Re, AXA, Liberty and Mitsui Sumitomo

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 Insurance), for the policy year ending in October 2018. The coverage is triggered by
the intensity of the event with an approximate loss probability of 1 in 10 years.

6 A Case Study
This is an illustration of a hypothetical case of parametric insurance designed to protect
individuals and small businesses against earthquake risk in California, the US. We assume
that this product is available from a private insurance company and without any assistance
from the public sector. We highlight other key assumptions as follows.
Market Opportunity. Earthquake risk is a well-known yet under-insured risk in Cal-
ifornia. The state government requires all licensed insurers in the homeowner’s insurance
market to offer an earthquake insurance coverage as an endorsement. Homeowners are,
however, not required to purchase this additional coverage. The California Department
of Insurance reports that only about 10% of homeowners in the state are insured against
earthquake-caused losses and that the buyers must assume a large franchise deductible (for
example, 5% to 20% of the property value). Anecdotal evidence suggests that many home-
owners dislike the large deductible requirement and the deductible itself discourages some
homeowners from buying the earthquake coverage. Parametric insurance can offer the home-
owners an alternative to reduce, if not eliminate, the deductible burden. Like JumpStart,
one may design a parametric insurance policy to offer a fixed sum of payment that eligible
insureds may use to cover their expenses immediately after the loss event.
Data. We use the data from the US Geological Survey (USGS), a government agency. It
publishes data on historic earthquakes with hazard information at a high spatial resolution.
The USGS also publishes shakemaps (maps of ground motion and shaking intensity) within
24 hours - in fact, often in one hour - after an earthquake.
Model. The Peak Ground Velocity (PGV), which is expressed in centimeter per second
(cm/s), is one of the most vigorous measures of earthquake aptitude (or shaking intensity).
It is also the measure that correlates closest to damages during a severe earthquake in a
particular area. Generally, the higher the (Richter) Magnitude of an earthquake, the more

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damages the earthquake is likely to cause. However, the magnitude alone is by no means a
reliable determinant of the damages likely experienced by a particular area, as local shaking
intensity is further affected by factors such as the distance to the epicenter and the local soil
condition. PGA represents the intensity of shaking a particular area experienced during an
earthquake, and PGV maps can be spatially overlaid with economic data at a very granular
geographic level, for example, a census block or a census block group.14 In this hypothetical
case, an earthquake has to reach a certain PGV intensity in at least one census block in
California to trigger the coverage.
Trigger. In this hypothetical case, we assume that a covered loss event has occurred
if an insured property is within a census block group and if any part of the census block
group experienced a shaking with a PGV of at least 30 cm/s during an earthquake. All
aftershocks within 7 days (or 168 hours) following the triggering earthquake are counted as
a single event.15
Claim Payment. Pure parametric insurance products tend to offer a small, fixed
amount of payment to each eligible insured. We thus set the claim payment arbitrarily
at $10,000 for a single event, subject to the annual maximum payment of $20,000 regardless
of the number of triggering earthquakes.
Simulation. Given that large earthquakes are infrequent, we run simulations based
on a fairly complete list of damaging earthquakes during the past 30 years (1989-2018) that
affected any part of California. Table 2 shows the estimated number of affected housing units
if a major earthquake hit the same area in 2017. Figure 4 depicts the simulation results if
the 1994 Northridge earthquake would have repeated in the same area in 2017. Based on
the findings summarized in Table 2 (alternatively the percentage of property value affected
over the past 30-year period), we can calculate the pure premium rate as follows:16
14
The census block is the smallest geographic unit the US Census Bureau uses, whereas the census block
group is the smallest geographic unit for which data is publicly available. There were 710,145 census blocks
and 23,212 census block groups in California according to the 2010 census.
15
This trigger resembles closely the one that JumpStart uses. JumpStart uses census block instead of
census block group as their measurement of a geographic unit.
16
Our premium calculation is based purely on the results of our simulation of USGS data and thus does
not reflect any other factors that can affect the final premium rates that insurers may offer.

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 Table 2: Simulation of Major Earthquake Impacts in California

Earthquake event Estimated number of housing units (based on data

in 2017) for which parametric insurance payments
could be triggered payments could be triggered
Loma Prieta earthquake (1989) 813,746
Northridge earthquake (1994) 1,053,985
Central California earthquake (2003) 18,223
Baja earthquake (2010) 36,422
Napa earthquake (2014) 33,914
Entire California 13,996,299
The number of housing units is estimated based on census block group data from the 2017 US
census. The California census map is overlaid with each earthquake intensity map (as illustrated
in Figure 4) and the number of housing units in each claim payout area has been estimated.

ΣEarthquakes in a 30-year period Affected housing units ÷ (Total housing units × 30) = 0.466%
Therefore, for a parametric insurance policy offering a fixed claim payment of $10,000
per claim and per annum, the average annual pure premium for homeowners in the area
would be $46.60 for a 1-in 30-year event. The pure premium rate for a 1-in 20-year can
be calculated, for example, by repeating the simulation 11 times for each of the 20-year
period. The result shows that the premium rates range from 0.032% to 0.674%. The large
variation exists due to the unpredictable nature of a single large earthquake event. The final
premiums are, of course, subject to the loadings the insurer adds as well as the risk profiles
of prospective insureds in different regions of the state. Evidence indicates that property
owners living in shakier parts of California demand more earthquake insurance than those
living in lower risk parts (Lin, 2016).
Basis Risk Management for the Insurer. Basis risk can be minimized through
utilizing a granular level of data. For example, the parametric trigger can be measured at
the level of the census block (that is, as small as a fraction of a mile in densely populated
areas).
There needs to be a balance between the granularity of measurement (minimizing basis
risk) and the ease to clarify the contract to consumers. A typical homeowner or renter would

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understand the trigger more easily when it is based on a particular earthquake magnitude
rather than when it is based on a census block application and a PGV analysis.

Figure 4: Left: the areas impacted by each level of PGV during the 1994 Northridge
earthquake. Right: Highlight of the areas with a PGV of at least 30 cm/s (red and dark
orange) that would reach the parametric trigger level. The geographic boundaries shown in
the figure represent census block groups.

Source: Author calculation based on the USGS data.

There is a concern related to scaling the index: consumer awareness, especially in the
case of low-frequency, high-severity natural catastrophe risk, will always be a challenge. This
challenge is shared by traditional indemnity insurance. As consumers keep paying premiums
without seeing a payment, the take-up of insurance will be low.
Demand for catastrophe insurance often experiences “availability bias”, which refers to
the tendency of people to rely on recent experience to inform choices. For example, the
demand for insurance covering a catastrophe risk tends to rise immediately after a disaster

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but unlikely for any extended period unless there is another disaster.17 Separately, merely
mentioning the word “insurance” may lead to a negative perception by some consumers.18
Parametric insurance can clarify it better than indemnity insurance what losses are covered
and what are excluded, especially when it is designed for named peril.
Mitigating Adverse Selection The insurer may structure premiums in a way that
mitigates adverse selection problems, such as taking into account modeling differences of
a geographic unit’s inherent risk. For example, we can map out the inherent seismic risk
variation across California using the Peak Ground Acceleration (PGA) measure provided by
the USGS (Figure 5). The data from this exercise can be used as a basis for determining
premium variations across geographic units.

7 Conclusions and Discussions

Parametric insurance has emerged as an innovative solution to the growing protection gap
in the insurance market. It has the potential to expand the role of insurance to better
protect the financial security of individuals, businesses and public agencies and to enhance
the economy for sustainable growth.
The traditional insurance market, which is dominated by indemnity principle-based con-
tracts, has focused on managing adverse selection and moral hazard problems. Insurers ex-
ercise vigorous underwriting to minimize the adverse selection problem and thorough claim
assessments to minimize the moral hazard problem. Underwriting and claim assessment help
insurers price risks fairly and indemnify their insureds for qualified losses. This traditional
insurance structure, however, leaves gaps in insurance coverages. Some insureds fail to meet
the underwriting guidelines that insurance companies impose. The structure also comes
17
Gallagher (2014) finds that the take-up of flood insurance in the US spikes after each damaging flood
but then steadily declines to baseline. Only a minority of US homeowners living along the coastline keep
flood insurance policies; only about 10% of Californian homeowners keep earthquake insurance policies (Lin
2016).
18
In the US, a standard homeowner’s insurance excludes coverage to perils such as flood, earthquake, and
mudslide, which is not always clearly communicated to homeowners. To further complicates the matter, a
standard homeowner’s insurance policy may cover the loss when an earthquake causes a fire that damages
an insured home but unlikely when an earthquake damages the home directly.

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Figure 5: California Earthquake hazard map generated using USGS gridded data (0.05-
degree longitude by 0.05-degree latitude).

Source: Author calculation based on the USGS data.

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with significant loadings for insurers to take care of underwriting, claim and other transac-
tion costs, thus likely forcing some insureds to select a higher deductible or coinsurance or
assume a lower policy limit as a means to lower their premium expenditure. This coverage
availability and affordability issue remains a major concern.
Insurance based on the parametric principle can be a solution to the aforementioned
problems. It can be a supplementary coverage to fill the underinsured gap in traditional
insurance. Parametric insurance allows insurers to significantly lower their underwriting and
claim assessment costs, thus providing a solution to the problem of protection gaps involving
the poor and other under- and uninsured population. Parametric insurance is based in
principle on the analysis of loss events, thus allowing insurers to be innovative in designing
new types of protections against the risks that would not meet the criteria for the indemnity
insurance business. For example, parametric insurance products not only can be designed to
protect the insureds from the loss of assets or revenue, but also can be designed to protect
them against extra expenses no matter whether loss of physical assets occurs.
Regarding the regulation of the insurance business, no countries are known to bar the
provision of parametric insurance in their jurisdictions. On the one hand, governments gen-
erally do not use a peculiar definition of insurance but a collection of principles to evaluate
whether a contract is subject to insurance regulation. On the other hand, there remains
a clear line between what constitutes insurance as compared to financial derivative prod-
ucts. Specifically, insurance acts commonly require the presence of insurable interest in all
permitted policies, implying that, at the minimum, there needs to be a record that claim
payments are made to the insureds who have been financially affected by a covered event.
We note that, in selected parametric insurance policies, such records can be automatically
generated (for example, flight delay coverages). In fact, the use of a full smart contract can
not only lessen the cost of record collection but also enhance the policys compliance with
local regulation.

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