Parametric insurance, also known as index-based insurance, is a type of insurance in which an insurance company and a customer agree on an amount that will be paid if a specific event occurs. The event must be measurable and, in order to be paid, its intensity must meet or exceed pre-agreed parameters or indices, such as wind speed, rainfall or earthquake magnitude.
Unlike traditional insurance, parametric insurance does not involve risk assessment or loss assessment. Instead, it relies on trigger points. The insurance company and the insured agree on a parameter index that assumes that when an event reaches a certain level, the probability of the insured suffering a financial loss is high. If such an event occurs, the insurance company will compensate according to the contract. This approach increases transparency, expedites claims payment, and provides insureds with immediate financial relief.
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Let us understand this by taking the example of the Government of India’s Weather-Based Crop Insurance Scheme (WBCIS), which leverages parametric insurance. The scheme aims to protect farmers from financial losses caused by extreme weather conditions such as rainfall, temperature, wind, humidity and so on. Assume that the heavy rainfall index is set to 12 mm per hour. When rainfall in the insured area exceeds this threshold, benefits are triggered.
Another example is extreme heat income insurance, designed to protect underserved communities from lost income caused by severe weather conditions such as heat waves. When heatwaves intensify to parameter trigger levels, workers will receive daily wages without having to work that day. This not only protects them from loss of income but also from poor working conditions. This insurance solution has been taken shape in Gujarat to support women workers in the unorganized sector.
Where else can parametric insurance be used?
Although parametric insurance is primarily used in weather-related and natural disaster scenarios, it is not limited to these. It can also cover financial stress due to non-asset loss business interruptions, production disruptions, excess or lack of green energy solar and wind energy, network outages and other measurable events.
The renewable energy industry, which is expected to grow significantly in the coming years, often relies on sunlight and wind as its primary energy sources. Historical data can be used to estimate expected solar irradiance for a given period. Sometimes, there can be unexpected shortfalls in solar power due to reasons such as cloud movement and atmospheric attenuation.
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This deficiency can be compensated when its economic value exceeds a parameter threshold. Such reporting helps to boost the confidence of private investors, encourage further investment in renewable energy and support environmental measures.
It can also be used to compensate for reduced footfall by traders due to curfews imposed by the authorities. When footfall falls below average, pre-agreed payouts are triggered.
Parametric insurance offers a unique and innovative approach to risk management. By eliminating the need for traditional loss adjustments, it provides a more efficient and transparent solution for businesses facing a variety of risks. Predetermined indemnity structures and reliance on objective trigger points ensure prompt financial relief, allowing policyholders to recover quickly from adverse events.
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As technology continues to advance, we expect parametric insurance will expand into new areas of risk, providing businesses with greater flexibility and protection. Parametric insurance has the potential to mitigate financial losses and build resilience, and is expected to become an increasingly valuable tool in the modern business environment.
The author is Chief Technology Officer at Bajaj Allianz General Insurance.
