Monte Carlo method to valuate CAT bonds of flood in Surabaya under Jump Diffusion Process

Abstract

The characteristic of natural disasters is that they tend to be rare. However, once they occur, natural disasters can result in enormous losses. In Indonesia, the natural disasters that cause the most losings are floods. Insurance companies will suffer immensely if many policyholders make claims due to losings from this natural disaster. Therefore, a financial instrument is urgently needed to transfer this risk to another party who is better at bearing the risk of loss. This financial instrument is called a CAT bond. The causes of flooding diverge into the hydrological aspect and hydraulic aspect. Maximum rainfall affects the hydrological aspect. In this research, we use a study case of flood in Surabaya. The maximum rainfall is predicted using the Gaussian Process Regression. Furthermore, the losses due to flooding obtained are modeled by the Jump Diffusion Process. The MAPE value obtained by the Jump Diffusion Process is much smaller than the Diffusion Process. From the results of the Monte Carlo simulation, it leads to the conclusion that the trigger value of the CAT bond contract significantly affects the CAT bond price, while the interest rate and the reduction proportion have a slightly significant effect.