Index-based insurance, also known as index-linked insurance, weather-index insurance or, simply, index insurance, is primarily used in agriculture. Because of the high cost of assessing losses, traditional insurance based on paying indemnities for actual losses incurred is usually not viable, particularly for smallholders in developing countries. With index-based insurance, payouts are related to an "index" that is closely correlated to agricultural production losses, such as one based on rainfall, yield or vegetation levels (e.g. pasture for livestock). Payouts are made when the index exceeds a certain threshold, often referred to as a "trigger". By making payouts according to an index instead of individual claims, providers can circumvent the transaction costs associated with claims assessments. Index-based insurance is therefore not designed to protect farmers against every peril, but only where there is a widespread risk that significantly influences a farmer's livelihood. Many such indices now make use of satellite imagery.

Traditional insurance schemes are susceptible to morally hazardous behaviors. To ensure that a given claim is legitimate, time and resources must be allocated to adequately audit the losses or damages incurred from an event. Index-based insurance attempts to reduce costs by circumventing the issue of moral hazard, thereby eliminating the administrative costs of claims auditing. This is possible because index-based insurance insures against risks that can not significantly be manipulated through human intervention (e.g. extreme weather). Unlike other insurance, adverse events cannot easily be predicted statistically, large numbers of people tend to be affected at the same time (known as "concurrency" by the insurance industry) and losses for each of them tend to be significant. The opposite is the case for more traditional insurance such as home theft insurance, where actuaries can make a good forecast of the likely incidence of claims, thefts are (relatively) rare, all the houses on a block are not entered at the same time, and entire contents of a house are not usually stolen.

Insuring risk in small-scale agriculture faces particular problems that are not usually encountered by the broader insurance sector. Production relies on natural conditions, such as rain, temperature, and sunlight, which cannot be controlled easily by poorer farmers, other than by those with access to irrigation or plastic tunnels in the case of horticultural crops. Consequently farmers face problems on a regular basis.

Traditional insurance has two cost categories. First is the underlying risk that is being insured and, second, the costs involved in operating the insurance, such as carrying out individual risk assessments and loss adjustments. In the agricultural sector these costs tend to be high and premiums are often unaffordable for most poorer farmers. The fixed costs of loss verification make it uneconomic to investigate losses for small-scale agriculture producers whose total insurance premiums are small. In practice, this can lead to poor loss verification, morally hazardous behavior and high loss ratios for insurance companies.

In theory, index-based insurance can cover many farmers while avoiding the need for loss assessment and adjustment. This can reduce some administrative and implementation costs, and also has the potential to limit payouts caused by fraud or poor farming practices.

Although agriculture is the main application of index insurance, it can also be applied to other markets as a similar means of protection. Droughts and floods that cause water supply disruptions can lead to financial damage that, if not remedied quickly, can further snowball into long-term economic damage. Index-insurance could be used to cover the potential economic losses that might occur with water supply disruptions and similar perils that are heavily influenced by weather conditions.

Another unorthodox application of index-insurance is using it as a means of hedging. The use of index insurance by financial institutions and farm input suppliers who extend credit to low income farmers in developing countries may be a more cost-effective use and enable such bulk buyers of insurance to hedge against default by farmers and thus continue to deal with those who have a high risk of defaulting.

Index-based insurance does not always provide farmers with indemnities when they experience crop or animal losses and the indemnity payments sometimes do not accurately reflect the size of the losses they experience. This is because an index is based on a geographical area within which farmers may have different experiences with, e.g., rainfall. As a consequence some farmers may achieve a good crop when most others in the area experience a crop failure. However, under an index-based system all farmers receive payouts. This problem has become known as "basis risk". As a direct consequence of basis risk, farmers are usually reluctant to pay the same premiums for index-based insurance that they would for standard insurance. Reducing basis risk by incorporating newly upcoming data sources is of central interest in current research.