What is a Basis Risk?
The risk that the cat bond payout does not match the sponsor's actual losses, particularly relevant for parametric and index triggers.
Basis Risk
The risk that the cat bond payout does not match the sponsor's actual losses, particularly relevant for parametric and index triggers.
How it works in practice
A Caribbean insurer buys a parametric cat bond triggered by central pressure readings below 920 millibars within a defined grid. A hurricane passes just outside the grid but causes heavy losses to the insurer's policyholders from storm surge. The bond does not pay out because the parametric condition was not met, even though the insurer suffered real losses. The gap between the payout and the actual loss is basis risk.
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