What is basis risk in insurance and why should I care? - FloodFlash Commercial Flood Insurance (2024)

This blog will unwrap a term that most insurance experts know, but many clients do not. Despite that, it can have a huge impact on the way their insurance performs in a claim. We plan provide simple answers to questions like: what is basis risk in insurance? why is it a problem? what are the examples? and share what this can mean for a commercial flood insurance buyer.

What is basis risk in insurance?

“Basis risk” is like most things in the financial services sector. It’s a technical wrapping for what is, at its essence, a simple concept. In financial terms, it refers to when an investor is hedging (protecting their investments with counter investments), and the hedge (the safety net) does not cover the whole value of losses should the investment not work out. The risk is that they will lose money, even though they’ve made an effort to reduce the loss by hedging. (There are many things that do make the equation more complicated, but this will serve our purposes for now…)

The principle is very similar in insurance. Basis risk in insurance refers to the possibility that someone has purchased insurance, but the money they receive in a claim does not equal the full cost of that particular claim event. In other words, it’s when the expectation of the policy from the client doesn’t match what they thought they would be paid out.

Why is basis risk a problem?

When you take the definition of basis risk as broadly as we have, it represents a huge problem. Consider what a mismatch in expectations between the insurer and the client can mean. When disaster strikes and they need to claim, the client will expect one amount of money, and receive another. They may not receive what they need to fully recover.

When it comes to insurance, the product is the claim. Clients may have been paying a premium for 20 years on the understanding that they will get a certain amount of money. When they don’t receive it in their time of need, the result is very unhappy clients.

Clients pass on that dissatisfaction and stress to the brokers and insurers that provide for them, as well as regulatory bodies that oversee disputes. Often the experience culminates in bad press for the insurance industry as a whole. Headlines emerge in which clients claim to have been short-changed, receiving less than they expected. When disagreements reach this stage, it’s often unimportant who is objectively “right”, particularly when one party is “less sophisticated” than the other and has a distinct disadvantage where evaluating insurance products is concerned.

A recent example of this emerged during the COVID pandemic. Businesses around the world assumed that they were covered for their losses. When insurers rejected non damage related business interruption claims, their clients were taken aback. There are 2,720,000,000 results from Google if you search for “COVID insurance complaints”. The majority of these will have come from a disconnect between what clients thought they had cover for, and what they were eventually paid when the pandemic hit.

What are examples of basis risk in traditional insurance?

If you consider our definition of basis risk then it exists in almost all forms of insurance. Traditional insurance often comes with terms that might reduce or exclude money during a claim, despite client expectations. These include, but are not limited to, the following:

Average clauses

Average clauses kick in when the client has underestimated the value of their property and potential business interruption losses (often captured in what’s called the ‘sum insured’ – a value for the total maximum payout). At the point of claim, loss adjustors may discover the sum insured value should have been higher. The result is that clients often pay a penalty (in some cases up to 50% of the claim value).

Many will say that this is caused by lack of disclosure or even fraudulent behaviour. This is certainly true in some cases, but businesses move fast, particularly during they major upheaval caused by COVID. To think that sum insured values will stay the same throughout a year long period for modern businesses is to make a major assumption.

Excesses

Having an excess on a policy means that the client is liable for a certain proportion of any claims. That means that they will pay the first £X towards their recovery. Excesses are much simpler than average clauses, and will form part of the initial conversation between insurer/broker and their client. Consumers are comfortable with excesses for travel, phone and home insurance, so it is less likely to cause a mismatch in expectations at claim.

That said, excesses still represent basis risk. If a small business that needs £100,000 to recover from disaster has a £10,000 excess on the policy, they only receive £90,000 in the event of the claim. Whilst the client may be aware of the implications of an excess, there is a difference between what they need and what they receive. And by that token there is basis risk, even if it has been accepted.

Exclusions

Exclusions are often the focus in the headlines when claims fall short. Clients often cite “hidden” exclusions that have lead to their shortfall. In fact, insurers and brokers are always careful to point out exclusions when they are introduced to a policy – almost always during a renewal/purchase conversation.

The issue arises from two areas. Firstly, clients assume that their commercial combined (or for homeowners their property) covers are comprehensive. The second is that exclusions can be in place for a long period of time often fading from memory. Insurers started to raise prices for pandemic losses after the MERs and SARs outbreaks given the perceived increase in risk. When clients reject paying more for specific covers they haven’t used, the insurer excludes the cover to keep prices the same.

This sounds like a reasonable exchange. But the conversation about SARs and MERs happened back in 2003/2004, just after the outbreaks. 20 years later, it’s difficult to recall a conversation about a small aspect of a complicated financial services purchase. Once again, we have a situation where the clients expectation is not the same as the terms in their contract.

Slow and incomplete claims

This last one is less concrete, but no less important from a client perspective. Taking our area of expertise as an example – claims administration speed is vital in limiting the impact of a flood. Traditional flood insurance claims can take months, if not years to settle. This brings several complications. Damp or mould can settle in and stress increases for everyone involved in the claim. Unfortunately it can also exacerbate basis risk.

When a business is out of action, many have cover for business interruption. This accounts for loss of revenue, and ongoing costs like wages, tax bills etc. For many businesses that experience a catastrophe, business doesn’t start at 100% as soon as they re-open though. Consider a retailer that has lost all its custom to a nearby store. Business interruption many only account for loss of revenue during the downtime. It doesn’t cover lost revenue caused by reputation damage or lost customers long term. Whilst the flood may have caused long term damage to revenue, the insurance claim only covers losses during closure. Put another way, the claim doesn’t meet the losses. Uh, oh. Basis risk again.

What is the basis risk in parametric insurance

Truth is, many commentators might suggest that basis risk is only an issue for parametric insurance. Ben Dyson’s great primer on the subject even asks the question “Could the basis risk ‘bogeyman’ threaten the rise of parametric insurance?“

The good news for FloodFlash fans is that the answer is a categorical no. In fact, basis risk is often easier to understand and counteract in parametric insurance. Compared to traditional insurance, parametric insurance has relatively simple terms. That means that averages, excesses and exclusions are easier to spot (if they exist at all – FloodFlash policies have none of these things). Basis risk comes from the trigger measurement or the chosen payout.

Choosing a trigger

The key part of any parametric policy is designing the trigger. It’s important that the trigger chosen closely correlates with the loss experienced by the insured. Catastrophe insurance provides us with some of the simplest examples. Wind speed, ground shaking or flood depth can all represent measures for a policy trigger for wind, earthquake and flood insurance respectively. Complex risks (like hurricanes) can benefit from multiple different triggers – eg. wind speed and flood depth.

Now we know what data we need for the trigger we need a way to measure it. This is where basis risk can creep in. If you are using measures like distance from the eye of a hurricane as your measure or flooding at a local river gauge, that means the measurement is happening at a certain distance from the insured property. In other words, whilst the wind speed or flood depth might correlate, there is margin for difference. That’s why at FloodFlash we place sensors at the insured property, rather than using local rainfall and river gauge data. A sensor on the property is the best way to measure flooding at that property – the best way to make sure the trigger correlates with potential losses.

Setting a payout amount

The second way in which basis risk can creep into parametric covers is in the selection of payout values. If you select a payout value above or below the losses you will suffer, there is a risk of over or underpayment. In order to combat this form of basis risk it’s important to consider what needs protecting before taking out the cover. In essence, this represents the fundamental difference between parametric and indemnity cover. For parametric insurance, the loss adjustment happens before the loss.

Most parametric insurers and brokers provide advanced guidance on what to consider when selecting payout values. The questions we ask are parallel to those asked by traditional insurance: what is the value of your stock? what about the building and any fixtures? what are monthly revenues? Surveyors are experts in taking clients through the process in more detail.

Even after the guidance and surveys, parametric skeptics tend to suggest there’s still a risk to miscalculate and low-ball what you need. That stands true for traditional insurance too though. Parametric policies will pay out what you’ve asked for, whereas traditional covers might penalise you through averages – so either way there is a risk.

How can I combat basis risk in insurance?

The simplest answer to this question is: arm yourself with knowledge. If you have a strong understanding of the terms in your insurance contract, you are less likely to fall foul of basis risk that threatens the survival of your business or the value of your home.

For traditional insurance:

• pay close attention to terms and exclusions. These can come in the form of endorsem*nts at the very bottom of a policy document, so be vigilant
• review your sums insured at renewal to make sure you won’t fall foul of average terms at claim
• make sure you are comfortable with excesses on your policy
• shop around. Just because you have an exclusion or excess with one insurer, it doesn’t mean others won’t offer you full terms

For parametric insurance:

• consider how the trigger for your policy is being calculated. Does the trigger correlate with potential losses? Where are the measurements taken?
• if you aren’t sure about the above, consult an surveyor who can support you on your exposure
• consider what you will need from a particular catastrophe. For flood we ask questions like:
  • what is the value of stock we would lose?
  • how much to dry out/repair the building?
  • would we lose any revenue?
  • what would our wage bill be to hold onto employees whilst closed?
  • is there any long term interruption of business from reputation damage?
  • what costs might we incur to keep the business open at another site?
  • do I have to rehouse tenants temporarily?
  • what was the value of any previous claims?

Basis risk and cash flow – finding a balance

Accepting basis risk is a part of insurance. When it comes to parametric insurance, by answering some of the questions above will get you to a claim value that will help keep your business going. If you’re buying commercial flood insurance, it’s more important to have money so that your business can recover once the waters have subsided rather than having perfect indemnity (if there is such a thing) months later. Particularly if the money goes to the liquidators during the closure.

Parametric insurance is all about protecting the cash flow. If you have the cash to survive after a catastrophe, then your insurance has done its job. Picking payouts can be as much about budgets as needs – so it’s important to find balance. That way you can decide when you are happy with your level of basis risk.

With the help of broker and insurer guidance you can get there so the next catastrophe doesn’t mean the end of your business.

To find out more about more about our award-winning parametric flood insurance visit our homepage.