There could be a difference between the actual loss incurred by the ceding company for the catastrophe event and the contractual recovery afforded under the Industry Loss Warranty Contract, this…

Question

Options

• Aabsolute risk
• Bcontract risk
• CLoss adjustment risk
• Dbasis risk

• A
  10% (5)
• B
  4% (2)
• C
  4% (2)
• D
  81% (39)

Explanation

Basis risk is the correct answer because an Industry Loss Warranty (ILW) contract pays out based on an industry-wide loss index (e.g., PCS estimates) rather than the ceding company's actual losses. This creates a gap - the insured may suffer heavy losses but receive little recovery if industry losses are low, or vice versa. That mismatch between the trigger metric and the actual loss experienced is the definition of basis risk.

Why the distractors are wrong:

• A. Absolute risk is not a standard insurance/reinsurance term in this context - it doesn't describe the index-vs-actual-loss mismatch.
• B. Contract risk generally refers to the risk of a counterparty failing to honor a contract (i.e., credit/default risk), not the structural gap in how losses are measured.
• C. Loss adjustment risk relates to uncertainty in how losses are settled or adjusted over time, not the difference between an index trigger and actual incurred losses.

Memory tip: Think of basis as the base on which the contract is measured. If that base (the industry index) doesn't match your own loss experience, you have basis risk - like measuring your height in the wrong shoes. ILW = industry trigger ≠ your loss = basis risk.

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