Gap between the payout provided by a parametric or index-based ILS trigger and the sponsor's actual loss, arising because the measured index or parameter does not perfectly correlate with the loss.
Basis risk is a central concept in the design of Insurance-Linked Securities and parametric insurance. It refers to the potential gap between the compensation received by the sponsoring cedant of an ILS instrument triggered by a non-indemnity trigger (parametric, index or modeled loss) and its actual loss. This discrepancy can be positive (the sponsor receives more than its actual loss) or negative (the sponsor receives less or nothing, despite a significant actual loss). Negative basis risk is the structural problem of non-indemnity triggers: if a cyclone strikes a zone slightly different from the one parameterized, or if the intensity measured by the reference weather station diverges from the real impact on the sponsor's portfolio, protection is less effective than expected. Positive basis risk creates a different moral hazard: the insurer may be tempted to concentrate underwriting in zones least correlated with the triggering index to maximize payouts in the event of a loss. Quantifying basis risk is an actuarial discipline in its own right, requiring modeling of the correlation between the triggering index and the actual portfolio over loss history. The choice between an indemnity trigger (zero basis risk but higher premium) and a parametric trigger (lower premium but potential basis risk) constitutes the fundamental trade-off in ILS structuring.
During Hurricane Irma in 2017, some parametric cat bonds on the Caribbean were triggered by measured wind parameters, but several sponsors found that their actual losses diverged significantly from the compensation received, due to the cyclone's unusual track and geographic disparities in their exposure. These divergences fueled debate on the preference for indemnity triggers in sovereign issuances.
basis risk, risque de décalage, risque d'inadéquation