Understanding Basis Risk in Insurance Contracts

Article excerpt

ABSTRACT

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.

INTRODUCTION

Basis and basis risk are familiar terms in financial risk management. The degree of basis in financial hedges such as option and futures contracts can be indicative of their effectiveness as risk management tools. Although basis has not been a well-defined concept in insurance, the idea of analyzing the effectiveness of insurance contracts using an insurance contract basis measure seems a natural extension of the original finance application. The fundamental idea of basis as defined in the finance literature can be applied to insurance contracts as the difference between the loss incurred by the policyholder and the indemnity actually paid out for that loss under the insurance contract. When this difference is unexpected by the policyholder, a legal dispute alleging breach of the insurance contract commonly follows.

In a recent industry publication (Strategic Risk Management Roundtable, 2004), several Fortune-500 risk managers were asked various questions concerning strategic risk management in their firms. In response to a question about how the insurance and reinsurance markets were affecting these risk managers, Kenneth Krenicky, Senior Vice President, Risk Management, at Aventis Pharmaceutical stated,

"Something else that is very important in my industry is the perception-and there is some reality to it-that there is difficulty settling your claim when you have one. With a major risk management account you often have huge claims. Risk managers, as well as their senior management, at times get very frustrated if, at the time of the claim, your partner, the insurer, becomes a second front in a two-front war. You have your plaintiff's counsel that you're fighting, and now all of a sudden, you are in a battle once you receive your reservation of rights letter. It is a problem because the insurer suddenly becomes an adversary in many ways."

Mr. Krenicky's quote illustrates the importance of analyzing this area of insurance contract nonperformance in greater detail. There is demand for knowledge about this issue in the risk management and insurance community, especially given that such nonperformance can result in so much litigation over the applicability of insurance coverage. Insurance companies should desire to understand this better as well because of the direct impact policyholder opinions in this area might have on perceived product quality.

According to data collected by the Federal Judicial Center (2001 ), total breach-of-contract litigation resolved in 2001 across all U.S. federal district courts represented almost 19 percent of all federally filed litigation in that year. Of those breach-of-contract cases, a little more than 16 percent (N = 7,506 cases) were specifically breaches of insurance contracts, representing the third highest percentage of breach-of-contract litigation out of 11 categories described. …