When catastrophe strikes, it is not unusual for the insurance payout to differ from the policyholder’s expectation. The possibility of such a discrepancy is referred to as “basis risk”. The term, however, can be ill-defined and easily misunderstood.
Therein lies the problem, without definition it is easy for the basis risk associated with a structure to remain unidentified and unquantified. If left unspoken, basis risk can lead to problems down the line, when events do occur. So, as a starting point, we can most simply define basis risk as the “difference between expectation and outcome”.
Imagine you are a government minister responsible for disaster response. Five days have passed since the hurricane hit your country, and the floods have still not receded. Tens of thousands of your citizens have been made homeless. In the eyes of the people, the government is simply moving too slowly, and the press is baying for action. There is some reassurance though, as you know that over many years your country has paid premium into an international pooling scheme designed to provide substantial funds quickly when such a disaster strikes, to help pay some of the costs of recovery.
But then you hear from the regional multi-state insurance pool to which your finance minister has been contributing hard-fought annual premiums for the past decade. Your country is not going to receive a pay-out. In the scheme’s parametric formula, the value is below the threshold. You have discovered the toxic politics of basis risk.