Managing Basis Risks in Weather Parametric Insurance: A Quantitative Study of Diversification and Key Influencing Factors

Abstract

Weather parametric insurance relies on weather indices rather than actual loss assessments, enhancing claims efficiency, reducing moral hazard, and improving fairness. In the context of increasing climate change risks, despite growing interest and demand,, weather parametric insurance's market share remains limited due to inherent basis risk, which is the mismatch between actual loss and payout, leading to loss without payout or payout without loss. This paper proposes a novel empirical research using Monte Carlo simulations to test whether basis risk can be managed through diversification and hedged like other risks. Key findings include: Firstly, portfolio basis risk and volatility decrease as the number of contracts increases. Secondly, spatial relationships significantly impact basis risk, with risk levels correlating with the ratio between insured location, weather station, and disaster footprint radius, and thirdly, event severity does not significantly impact basis risk, suggesting that catastrophic disaster severity should not hinder parametric insurance development.