According to the Bible (Genesis chapter 27), Jacob hoped to marry Rachel. He agreed to work for Rachel’s father, Laban, for seven years in return for permission to marry Laban’s daughter. On the wedding night, Laban married Jacob to Leah, Rachel’s sister. This is analogous to basis risk, a mismatch between contractual expectations and performance in finance.
Buyers and sellers of insurance, reinsurance, and derivative protection need to consider basis risk all the time by asking, Will a contract hedge risk as expected? Sometimes they do this explicitly, sometimes implicitly, and sometimes not at all.
Type 1 Basis Risk Analysis: Explicit Consideration in a Double Trigger Contract
Usually the front end of a cat bond is either an indemnity trigger reinsurance contract or a double trigger reinsurance contract consisting of an indemnity trigger and an index warranty. The index warranty might be as simple as: industry losses from a loss occurrence must exceed $20 billion. In this example, the protection buyer is indemnified for actual loss to the extent the index warranty is met.
The index warranty lowers the price of protection. In evaluating a double trigger contract, the protection buyer has to first have an expectation of recovery.
- What sort of event should it respond to? Is the company using the contract to hedge tail value at risk (e.g., a 200-year event will not result in a loss of more than 10% of book equity) or to protect a specific reinsurance layer?
- What is the probability of a shortfall relative to expectations?
- When will the company get indemnified for amounts within their retention (sometimes called an “over recovery”)?
- Is the discount worth the potential basis risk retained?
- How do you value over recoveries?
This exercise can prove challenging for all concerned. It requires skill and thoughtful analysis. As a client once told me: An over recovery will get me a pat on the back but a shortfall I didn’t warn my boss about will get me a pink slip.
Type 2 Basis Risk Analysis: Implicit Consideration in an Indemnity Trigger Contract
Where the front end of a cat bond uses indemnity trigger reinsurance, the buyer considers basis risk implicitly. Any insurance and reinsurance contract with exclusions, sublimits or similar features (including those concerning the timing of payment or agreed values), whether contractual or mandated by law, has the potential for basis risk. You could call this contractual basis risk.
For example, if an insurance contract covers cyber risk and the corresponding reinsurance contract excludes it, the insurer has to evaluate the potential for basis risk from cyber events.
Brokers, insureds, insurers and reinsurers evaluate exclusions, sublimits carefully without explicitly identifying the issue as basis risk but that is really what is at stake. In addition, market security analysis gets at another implicit form of basis risk, counterparty risk.
Basis Risk Ignored
Sometimes, even though basis risk is present, it is ignored.
Consider an insurance product that pays actual losses for many lines of coverage (e.g., property physical damage, business interruption, first party and third party liability etc.), with no exclusions whatsoever—provided that a natural catastrophe meeting some specified criteria occurs (e.g., an earthquake that ring the bells at Boston’s Old South Church). A broker or protection buyer usually focused on Type 2 basis risk analysis might be lulled to sleep by the absence of any exclusions etc. After all, “it covers everything” and the price is right.
Unfortunately, in this example, the buyer needs to do a Type 1 basis risk analysis to assess the value of the product that “covers everything” because, in fact, it doesn’t. If the bells fail to ring, the buyer gets nothing covered instead of everything. If this non-recovery varies from expectations, someone will be very upset.
Identifying, Assessing and Managing Basis Risk
Basis risk is unavoidable and neither unambiguously good nor bad. Ignoring it though is perilous. A good risk advisor can help identify basis risk by both clarifying expectations and analyzing contract terms, including any index triggers. Most importantly, an informed buyer can evaluate the inevitable tradeoffs in price and basis risk to make better decisions both potentially saving money and avoiding pink slips.