Disaster Risk Finance Instruments: Parametric Insurance for Disaster Response

Parametric insurance (also called index-based insurance) is a type of insurance that pays out when an event of a certain agreed-on severity takes place – that is, it does not pay out based on the actual damage or losses sustained. The objective measure that determines a payout is often known as the parametric “trigger.” The advantages and disadvantages of parametric over traditional indemnity insurance are always context-specific and depend on the objectives of the insured in securing financial protection.

In the context of parametric insurance for disasters, payout triggers are usually related to the intensity of an event and can take one of two forms:

1. Pure parametric trigger. With this type of trigger, the payout is based on physical characteristics of an event, such as the wind speed of a cyclone, magnitude of an earthquake, or amount of rainfall occurring in a particular location.

2. Modeled loss trigger. With this type of trigger, the payout is based on estimated losses for a given event from a catastrophe model.

It is possible for parametric policies to have multiple triggers, which can result in different levels of payouts. The main requirements for a parametric trigger are (i) that the measure is objective and can be modeled; (ii) that the measure is independently verifiable by a third party immediately after a disaster; and (iii) that the measure is correlated with the actual losses incurred following a disaster. Neither the insured nor the risk taker should be able to influence the trigger (or its calculation or reporting).