What is basis risk?

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Basis risk in index insurance arises when the index measurements do not match an individual insured’s actual losses. There are two major sources of basis risk in index insurance. One source of basis risk stems from poorly designed products and the other from geographical elements. Product design basis risk is minimized through robust product design and backed by testing of contract parameters. Geographical basis risk is a factor of the distance between the index measurement location and the production field. The greater the distance between the measurement instrument and the field, the greater the basis risk. Some households that experience loss may not receive compensation while others that experience no loss may receive payments. This basis risk is reduced when the area covered by the index is homogeneous both in terms of weather and in terms of farming techniques. Therefore, as the density of weather stations and satellite pixels is increased basis, risk is minimized.