Climate & Parametric Risk: Pricing a Moving Target
Faraday's read: traditional insurance measures your loss and then argues about it for eighteen months. Parametric insurance measures a number — wind speed, rainfall, a river gauge — and pays instantly if the number crosses a line, no adjuster, no argument. That speed is the whole point, and it comes at a price: basis risk, the gap between the trigger firing and your actual damage. Parametric is not a better mousetrap; it is a different animal for a different problem. The load-bearing question is never 'is it cheaper' — it's 'how tightly does the index track the loss I actually care about.'
Knowledge check
What is 'basis risk' in a parametric insurance product, and why is it the central trade-off a buyer must weigh?
Show the answer
Basis risk is the gap between the parametric trigger and the policyholder's actual loss — the risk that the measured index (say, wind speed at a reference station) does not fire even though real damage occurred, or fires when little damage did. It is the central trade-off because parametric insurance buys speed and certainty of payout by tying itself to an index rather than to your losses; the tighter the index tracks your real exposure, the smaller the basis risk, but a perfectly matching index is rarely available.