Basis Risk
The mismatch between a parametric or industry-loss trigger and the cedant's actual losses.
Basis risk is the potential gap between the payout mechanism of a reinsurance or ILS contract and the cedant's actual losses. It arises whenever the contract does not pay exactly based on the cedant's own verified loss experience.
In parametric insurance, basis risk is the difference between what the index measures (wind speed at a weather station, earthquake magnitude at an epicentre) and what the insured entity actually loses. A storm that misses the measurement point may cause severe losses without triggering a payout; conversely, a measured event may trigger payment while actual losses are minimal.
Basis risk is a fundamental trade-off in risk transfer. Eliminating it (indemnity cover) means slower claims settlement and more disclosure. Accepting it (parametric, industry loss) enables faster settlement, lower transaction costs, and capital market distribution — but leaves the cedant with residual unhedged exposure.
Example usage
“The Caribbean government accepted basis risk in its parametric hurricane programme to gain faster post-disaster liquidity.”
Frequently asked questions
What is Basis Risk?
The mismatch between a parametric or industry-loss trigger and the cedant's actual losses. Basis risk is the potential gap between the payout mechanism of a reinsurance or ILS contract and the cedant's actual losses. It arises whenever the contract does not pay exactly based on the cedant's own verified loss experience.
How is Basis Risk used in practice?
The Caribbean government accepted basis risk in its parametric hurricane programme to gain faster post-disaster liquidity.
More Catastrophe Bonds terms