Understanding Basis Risk in Insurance Contracts

There is a tremendous amount of resources being tied up in litigation between insurance companies and policyholders over things like the extent of coverage for various loss scenarios or allegedly bad faith delays in settlement payments. The fact that policyholders formally dispute insurer coverage positions or claims payment strategies gives credibility to the idea that mismatches exist between what policyholders expect insurance policies to cover and what the insurance contracts actually provide as loss indemnification. This mismatch essentially represents insurance basis risk, the analysis of which can more accurately reflect the value and overall efficiency of insurance contracts and suggest factors that may influence policyholder dissatisfaction and consequently insurance contract disputes. This article takes a detailed look at insurance basis risk and finds that subjectivity plays a prominent role in its definition. Using Bayesian inference, it is shown how factors can affect the magnitude of insurance basis risk depending on the individual situation in which the mismatch between losses and coverage exists.