Viewpoint: Rethinking Basis Risk in Structured Insurance Solutions

Insurance solutions—more broadly referred to as risk transfer—that are parametric in design have become a common point of conversation between insurance buyers and their risk advisors when discussing protection options. These alternative risk transfer products are widely viewed as complementing traditional, indemnity-based property insurance.

While a parametric insurance payment is triggered based upon a transparent, observable index, indemnity insurance is triggered based upon a dollar loss amount assessed by a claims adjuster. This difference in triggers can cause insurance buyers to express concern about basis risk. A deeper look suggests basis risk is not limited to parametric insurance—it is surprisingly prevalent in traditional forms of insurance as well.

Generally, across the capital markets, basis risk is defined as the mismatch between the value of an asset and the hedging instrument used to protect the value of the asset. With parametric insurance, basis risk arises when a product’s triggered payments do not match exactly an insured’s actual loss. This can happen due to improperly designed coverage parameters, the chosen parametric trigger, and unforeseen factors causing loss.

For example, a parametric insurance product designed to cover hailstorm damage might not pay out if the observed size of hailstones is smaller than the size that triggers payment, or the hail doesn’t fall in the predefined area of coverage. In either case, the payment from the product may be different from the insured’s actual property damage.

In fact, traditional insurance products also have basis risk. Basis risk can arise from factors such as improper claims handling, exposure mismanagement, and inflated repair or replacement costs due to inflation or opportunistic contractors who approach homeowners following a loss event. In addition, coverage ambiguity can result from deductibles and self-insured retentions, sublimits, exclusions, and terms and conditions within the policy language. For these reasons, traditional insurance may produce payments that differ from the expectation of the insurance buyer.

It is important to remember that insurance and other forms of risk transfer are hedges. They are intended to offset loss, but the degree of offset might be imperfect. Nevertheless, the insurance industry has made great advances in developing sophisticated risk transfer solutions that merit consideration.

Useful features of parametric insurance

Parametric insurance has numerous advantages that make it a valuable tool in transferring risk. Among these are:

• Simplicity. Parametric coverage is straightforward, and payout triggers and indexes are based on a pre-determined metric, making the coverage terms easy to understand.
• Customizability. Complex risks can be addressed through parametric solutions, with customized, scalable parameters designed for a specific buyer’s risk management and budget.
• Claims transparency and efficiency. Because parametric coverage and payout conditions are known up front, the claims process is transparent and efficient. A lengthy adjudication process is avoided with parametric insurance, which facilitates claims settlement far faster than traditional indemnity coverage.
• Complementarity. Parametric coverage works well as part of a holistic risk transfer strategy, as parametric solutions can fill in gaps left by traditional indemnity coverage.

Basis risk introduced by catastrophe modeling

Commercially available catastrophe models are used widely in the insurance market. Modeling catastrophe risks has become essential for insurance companies, and indeed, many use catastrophe models to quantify risk and define risk management objectives. Catastrophe models have limitations that can introduce basis risk, however.

The skill of catastrophe models varies depending upon the nature of the loss being predicted. Catastrophe models were originally designed to predict the occurrence of rare, severe events and their losses. As a result, they typically show higher efficacy when predicting losses caused by primary perils such as hurricanes and earthquakes. Such perils are infrequent and tend to have high return periods, e.g. 1-in-100 years, 1-in-250 years. The models usually show lower efficacy when predicting losses caused by frequent, less severe events. These “secondary perils” have much lower return periods – such as 1-in-5 years or 1-in-10 years – and existing catastrophe models do a poor job of predicting those kinds of high-frequency losses.

Innovative modeling techniques can reduce the basis risk of parametric products

Parametric insurance design improves as data on risks and loss–and innovative applications of those data—become more abundant. For example, experiential modeling, rather than referential modeling, can be more skillful in predicting loss caused by frequent, secondary perils. By leveraging decades of hourly weather data from trusted, transparent weather data providers and extensive records of peril-specific claims and exposure data, a modeler can significantly improve skill in predicting an insurer’s frequent natural peril losses on a ground-up basis. Basis risk in this approach is minimized because the model is trained on the actual loss experience stemming from an insurer’s actual book of business.

Not all parametric insurance products and models are created equal. When a risk is modeled properly and the parametric insurance is calibrated correctly to a protection buyer’s exposure, basis risk can reduce significantly relative to other parametric or indemnity insurance products.

Parametric insurance can offer substantial benefits in transferring risk. For example, insurers struggle to find and purchase affordable protection from reinsurers for frequent severe convective storms (i.e. day-to-day thunderstorms) and their sub-perils of hail, tornadoes, and strong wind. However, when the risk is modeled experientially and packaged in a validated modeled loss index, both insurers and reinsurers can agree on a view of risk that results in a reinsurance transaction that is economically viable to both parties.

Recognizing that basis risk exists in traditional insurance products and models is a critical step toward improving risk management and making informed decisions about when to deploy parametric insurance products. A protection buyer is then well-equipped to design and execute a risk management strategy that prescribes the appropriate insurance product for a particular risk.

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