Basis risk

Basis risk is the difference between an index and the shock that the index is supposed to be a proxy for. A payout triggered by an index may be higher or lower than the beneficiary's losses, leading to overpayment or shortfall respectively. Where there are differences of opinion amongst stakeholders over what the index is supposed to be a proxy for, the precise definition of basis risk can be contested. For example, disagreement may arise over whether an agricultural insurance product that uses a rainfall-based index covers drought-induced crop disease and pest damage (Centre for Disaster Protection).