SA2- Chapter 11, Pg 15, core reading 3( second last paragraph of the page)

The core reading states that “ The benefits of risk mitigation techniques can be recognised in the SCR, provided any basis risk(ie. mismatch between the risk and it’s mitigation technique) is immaterial or can be reflected in the SCR. Could someone please explain the meaning of this whole paragraph?

 

Consider the following example. An insurer only owns Apple stock and decides to hedge its market risk by purchasing index put options.

The option provides risk mitigation in the case of an equity shock.

A fall in equities reduces the value of the insurer’s Apple portfolio but increases the value of the put option. The hedge reduces the portfolio loss and reduces the SCR as a result.

However there is basis risk because the hedge is based on an index and not the insurer’s actual asset portfolio.

Such basis risk can be ignored if immaterial. Otherwise it will need to be reflected (i.e added) in the SCR.

Hope that helps.

 

I understand your example really well. Could you also please explain what is basis risk?

 

Sticking with the above example, basis risk arises because a £1 fall in Apple stock does not translate to a £1 increase in the derivative (here the put option) because it is based on a different underlying, ie an index.