Basis Risk

Basis risk in catastrophe bonds and insurance-linked securities is the risk that the payout from an ILS contract does not closely match the sponsor’s actual financial losses.

This is a consideration for sponsor’s when looking at different types of payout structures for ILS contracts. For example, an Indemnity Trigger is viewed as having low basis risk but also tending to be quite slow, while a Parametric Trigger can be much faster but is viewed as having higher basis risk (e.g., a “technically” strong hurricane could trigger a payout even if it causes no actual losses to the sponsor, while a “weak” but very wet storm could cause massive flood losses but fail to trigger the bond).

Rating agency AM Best explains basis risk as, “(Re)insurers issuing non-indemnity catastrophe bonds may be exposed to “basis risk,” which in the context of catastrophe bonds, generally reflects the possibility that a catastrophe bond may not be fully triggered (or triggered at all) for covered perils even when the sponsor of the catastrophe bond has suffered a loss due to those perils. ”

In some financial markets it is thought of as a method of measuring performance of hedges: the lower the basis risk the better the hedges performance. Essentially, the basis risk is related to imperfect hedging, and is the risk that the value of a futures contract fails to move in line with the underlying exposure.