Introduction

Parametric insurance is an increasingly valuable tool for developing countries to manage the devastating impacts of natural disasters such as hurricanes, earthquakes, and droughts.¹ Unlike traditional indemnity insurance, which reimburses actual losses incurred, parametric insurance provides rapid payouts triggered by predefined thresholds, such as rainfall levels or wind speeds. This allows governments to access critical funding within days of a catastrophe, helping to protect vulnerable populations, stabilize public finances, and accelerate recovery efforts. However, the advantages of parametric insurance extend beyond national governments in developing regions. Public entities, such as cities, states, local agencies, and public entity risk pools, can also leverage parametric insurance coverage to strengthen disaster preparedness, close protection gaps, and secure timely financial resources, all within the constraints of their limited budgets.

What is parametric insurance?

According to the National Association of Insurance Commissioners (NAIC),² parametric insurance (sometimes referred to as “index-based” insurance) is defined as a “type of insurance contract that insures a policyholder against the occurrence of a specific event by paying a set amount based on the magnitude of the event, as opposed to the magnitude of the losses in a traditional indemnity policy.”

In simpler terms, traditional indemnity insurance reimburses the actual losses incurred following the occurrence of a claim, with the final payment amount typically determined through a claim adjustment process that often involves significant delays, including litigation. In contrast, parametric insurance pays out a predetermined amount when specific measurable metrics, called the “trigger(s),” are met, regardless of the actual losses sustained.

These triggers must meet two essential criteria:

1. They must be independently and objectively measurable.
2. They must be able to be modeled.³

Once all trigger conditions are satisfied, the policy pays out the agreed amount promptly, often within days of the event. Some parametric policies may include multiple triggers or tiered payout structures based on the severity or intensity of the event (e.g., varying payout levels depending on wind speed thresholds during a hurricane).

Parametric policies are often best understood through a noninsurance example—sports betting. Consider horse racing, for example. At the racetrack, you can buy a ticket with a bet that a certain horse will win the race. The cost of that ticket would be analogous to the premium paid for a parametric policy. The ticket also specifies a predetermined payout if the chosen horse wins the race, based on the odds, similar to how insurance pricing reflects the probability of a covered event. The trigger in this example is straightforward: If the selected horse wins, the payout occurs; otherwise, there is no payout. This mirrors the structure of a parametric policy, where a predefined event triggers a set payment. The key difference, of course, is that in insurance, the payout is tied to incurring a financial loss rather than winning a wager.

Why is parametric insurance a great fit for public entities?

Public entities often rely on traditional indemnity insurance policies to protect their infrastructure and financial stability in the face of natural disasters. However, these policies can present several limitations, including:

• Delayed payouts: Claims assessments and adjustments can take a significant amount of time, delaying much-needed funds for recovery efforts.
• Coverage gaps: Traditional policies may not cover all types of losses, especially nonphysical costs such as emergency response, evacuation, and lost revenue.
• Underinsurance: Budget constraints can lead public entities to purchase less coverage than needed, leaving significant residual risk.

These limitations are a key reason why many developing countries have utilized parametric insurance as an alternative to traditional indemnity coverage.⁴ The benefits that make parametric insurance attractive in these regions are equally relevant for public entities. Both face budgetary constraints and are exposed to unique, often large-scale, risks. For public entities, the primary advantages of parametric insurance include:

1. Rapid disbursement of funds

One of the most significant advantages of parametric insurance is the speed of payout. Because payments are triggered by objective, predefined parameters, there is no need for a lengthy and time-consuming loss-adjustment process. This enables public entities to access funds quickly, which is critical for emergency response efforts (e.g., debris removal) and maintaining continuity of critical public services.

2. Flexible use of funds

Unlike traditional indemnity insurance, which often restricts payouts to the repair or replacement of specific assets, parametric insurance offers greater flexibility. Public entities can allocate funds as needed, whether for emergency operations, social support services, or infrastructure repairs, allowing for a more effective and timely response to disasters.

3. Closing protection gaps

Parametric products can be tailored to cover risks that are often challenging to insure through traditional methods, such as drought or excessive precipitation. This flexibility enables public entities to address coverage gaps and more effectively manage a wider range of risks.

4. Budget certainty and fiscal stability

Parametric insurance offers a predictable and transparent payout structure, which supports more effective financial planning and budgeting. By reducing the fiscal shock that often follows a disaster, it helps public entities maintain financial stability without resorting to emergency borrowing or diverting funds from other essential services. This predictability is especially important for public entities, which typically operate within strict budget constraints for insurance and disaster response.⁵

5. Incentivizing risk reduction

Parametric insurance can be designed to encourage risk mitigation, similar to that of a traditional indemnity policy. For example, public entities that invest in disaster preparedness or risk reduction measures may benefit from lower premiums or higher payout thresholds.

Considerations and challenges—basis risk

Parametric insurance offers several advantages, but it also comes with important limitations. Chief among them is basis risk, which refers to the potential mismatch between the policy payout and an insured’s actual losses.⁶ There are two primary types of basis risk⁷:

1. Positive basis risk: Occurs when a trigger is met and a payout is made, but the actual losses are less than the payout amount.
2. Negative basis risk: Occurs when a loss is sustained but the trigger is not met, resulting in no payout or an insufficient payout.

While positive basis risk may result in a surplus relative to actual losses incurred, this excess funding can be beneficial. Public entities can use the additional funds to address related or secondary needs, such as emergency response efforts, community support, or infrastructure improvements.

In contrast, negative basis risk poses a more difficult challenge. If a qualifying loss occurs but the trigger conditions are not met, the public entity may face a significant funding shortfall precisely when resources are needed the most. In such cases, the public entity may be forced to reallocate existing budgets, seek emergency borrowing, or wait for external aid—each of which can delay response and recovery efforts. Managing basis risk is therefore a critical consideration when designing and implementing parametric insurance solutions.

How can basis risk be minimized? This is where actuaries can help. By applying advanced modeling, data analysis, and thoughtful policy design, actuaries can help significantly reduce the mismatch between trigger-based payouts and actual losses. The following are several key considerations to minimize basis risk:

1. Advanced modeling and analytics: Using analytical techniques, particularly based on historical data (and catastrophe modeling), to simulate how the parametric trigger would have performed in similar past events. This retrospective testing helps identify potential gaps in coverage and ensures the trigger closely aligns with actual loss experience.
2. Careful trigger selection: Selecting parametric triggers that have a strong, proven correlation with actual losses for the specific peril, geography, and exposure type. The better the correlation, the lower the likelihood of basis risk.
3. Data quality: Using accurate, granular, and location-specific data is crucial to ensure that the trigger reflects conditions experienced by the insured.
4. Customized policy design: Structuring the policy to align with the public entity’s specific risk profile by adjusting trigger thresholds, payout curves, and coverage limits. Tailoring these elements helps improve the responsiveness and accuracy of payouts.

By taking these into consideration in the design and pricing of a parametric policy, actuaries can help ensure that payouts more closely reflect actual losses, thereby minimizing basis risk and enhancing the reliability and effectiveness of parametric insurance solutions.

Potential use case for public entities

Parametric insurance offers a range of potential applications for public entities, especially in the property insurance space. To better understand its value, let’s explore a specific use case that illustrates how parametric insurance can enhance a public entity’s overall risk management strategy.

Problem

A city located in a snowy region faces unpredictable and sometimes extreme snowfall during the winter. When snowfall exceeds a certain threshold, the city’s regular snow removal budget is quickly exhausted, resulting in delayed plowing, hazardous road conditions, and disruptions to public transportation and emergency services. Traditional insurance is often ill-suited for this type of risk, offering slow payouts and requiring detailed loss documentation.

Parametric insurance solution

To address this challenge, the city purchases a parametric insurance policy designed specifically for extreme snowfall events. The policy is triggered if total snowfall, as measured by the city’s official weather station, exceeds 20 inches within any 72-hour period. If snowfall is between 20 inches and 30 inches, the city receives a payout of $500,000. If snowfall is between 30 inches and 40 inches, the payout increases to $1,000,000. Finally, if snowfall exceeds 40 inches, the maximum payout of $2,000,000 is triggered. The following table displays these triggers and payouts.

If a major snowstorm meets or exceeds one of the defined thresholds, the weather data is validated by the insurer, and the corresponding payout is issued, typically within a few days.⁸ Because the trigger is based on objective, independently verifiable data, there is no need for lengthy loss adjustment or proof of actual costs.

The city can immediately use the funds to cover overtime, hire additional snowplows, buy more salt/sand, and ensure roads and essential services remain accessible. This rapid infusion of funds helps maintain public safety and continuity of services during severe weather events. Residents benefit from safer roads and less disruption during extreme winter weather.

This is just one of many potential use cases of how parametric insurance can help fund risks that are otherwise not easily insurable under traditional insurance policies.

A future for public entities?

Parametric insurance represents a transformative approach for public entities seeking to strengthen their risk management strategies both now and in the future. Unlike traditional indemnity insurance, which often involves lengthy claims processes and subjective loss assessments, parametric insurance delivers pre-agreed payouts swiftly and transparently based on measurable triggers such as rainfall, wind speed, or seismic activity. This rapid disbursement of funds enables governments, municipalities, and public agencies to respond more effectively to crises, ensuring that essential services—like emergency response, healthcare, and infrastructure repair—can be maintained or restored without delay.

Looking ahead, the benefits of parametric insurance for public entities are poised to grow even further. As climate change increases the frequency and severity of natural disasters,⁹ public budgets will face mounting pressure. Parametric insurance can provide a reliable financial buffer, reducing the need for emergency borrowing or budget reallocations that might otherwise disrupt vital public programs. Advances in technology, such as improved weather forecasting, satellite monitoring, and data analytics, will allow for even more precise and localized parametric triggers,¹⁰ minimizing basis risk and enhancing the alignment between payouts and actual losses.

By integrating parametric solutions into their broader risk management frameworks, public entities can enhance their financial resilience, better protect vulnerable populations, and ensure continuity of public services in the aftermath of catastrophic events. As awareness and adoption continue to grow, parametric insurance is poised to become an essential tool in how the public sector prepares for and recovers from the challenges posed by catastrophes and climate change.

¹ Spindle, B. (2024, July 12). Increasingly popular ‘parametric insurance’ helps farmers and others hit hard by extreme weather. Associated Press. Retrieved August 14, 2025, from https://www.ap.org/news-highlights/spotlights/2024/increasingly-popular-parametric-insurance-helps-farmers-and-others-hit-hard-by-extreme-weather.

² Parametric disaster insurance. (2023, December 21). National Association of Insurance Commissioners. Retrieved August 14, 2025, from https://content.naic.org/cipr_topics/topic_parametric_disaster_insurance.htm.

³ What is parametric insurance? (2023, July 7). Swiss Re. Retrieved August 14, 2025, from https://corporatesolutions.swissre.com/insights/knowledge/what_is_parametric_insurance.html.

⁴ The Caribbean Catastrophe Risk Insurance Facility. Retrieved August 14, 2025, from https://www.ccrif.org/?language_content_entity=en.

⁵ The impact of equal workplace claims on public entities. (2017, November 1). Risk & Insurance. Retrieved August 14, 2025, from https://riskandinsurance.com/impact-equal-workplace-claims-public-entities.

⁶ Hall, C. (2021, May 8). What is basis risk in insurance and why should I care? FloodFlash. Retrieved August 14, 2025, from https://floodflash.co/what-is-basis-risk-in-insurance-and-why-should-i-care.

⁷ Palwishah, R.I., Mazviona, B., and Sølvsten, S. (2023, December 18). Enhancing disaster resilience: Addressing basis risk in parametric insurance. WTW Research Network Newsletter. Retrieved August 14, 2025, from https://www.wtwco.com/en-ng/insights/2023/12/enhancing-disaster-resilience-addressing-basis-risk-in-parametric-insurance.

⁸ Gillon, P.M. (2025, May 2). Parametric insurance: The future-proof solution for enterprise risk. Policyholder Pulse. Retrieved August 14, 2025, from https://www.policyholderpulse.com/parametric-insurance-enterprise-risk.

⁹ Vernick, D. (2025, January 14). Is climate change increasing the risk of disasters? World Wildlife Fund. Retrieved August 14, 2025, from https://www.worldwildlife.org/stories/is-climate-change-increasing-the-risk-of-disasters.

¹⁰ How technology enhancements are boosting parametric. (2023, December 6). Aon. Retrieved August 14, 2025, from https://www.aon.com/en/insights/articles/how-technology-enhancements-are-boosting-parametric.