Basis risk in disaster risk financing for humanitarian action

In finance, ‘basis risk’ is the systematic or inherent risk accepted in hedging. In disaster risk financing (DRF), where statistical risk models are used to try and predict the outcome of a likely or current event—and can trigger the release of financing—basis risk lies in the combination of inherent model error, context outcome uncertainties, and miscommunication or misinterpretation of a model’s capabilities.

Clearly, as this paper sets out, in the context of humanitarian or crisis action, the ability of DRF systems to identify, calculate, reduce, and manage these risks is key to protecting lives, livelihoods, and assets.

High quality, objective data and risk models have the potential to significantly increase the neutrality and impartiality of humanitarian decision-making, to offer a new type of financing, and increased accountability. However, their ability to become a radical game-changer hinges on some key requirements around the identification of a new design lens on DRF systems for humanitarian purposes—and specifically, in this paper, the use of data and management of basis risk:

risk models need to be open, and the logical steps for decision-making clear to specialists and nonspecialists alike;

the certainty of uncertainty and error must be acknowledged, communicated, understood, and actively managed by all decision-makers, at all levels;

the data in the model must be representative of the risks experienced by the poorest people and households—not just the risks to large-scale economic assets;

those at risk should have the opportunity to inform both model and system design, and to contextualise and query them; l there needs to be a clear logic ‘line of sight’ between modelling and operational planning on the one side, and financing triggers, volumes and timing on the other;

models that trigger financing need to be able to take humanitarian complexity into account; they should be nested within wider national disaster management and response system and decision-making/data strategy; and they should be transparent and open, allowing financial providers to price competitively, and accountability to people at risk.

This paper offers a number of potential technical solutions to assessing, managing and reducing basis risk. It acknowledges that, in order to be effective, these need to be accompanied by political and coordination efforts, and a wider look at DRF operational systems that are fit for crisis settings. The authors invite further ideas and discussion on this topic, including any opportunities to test and innovate new operational designs.