Risk-based CAT bond pricing considering parameter uncertainties

Abstract

ABSTRACT Catastrophe bonds (CAT bonds) are risk-linked securities used by the insurance industry to transfer risks associated with the occurrence of natural disasters to the capital markets. Current formulations for the pricing analysis do not account for uncertainties in model parameters. Neglecting such uncertainties might lead to assuming risks that are higher than intended. This paper develops a risk-based bond pricing, considering the uncertainties in the model parameters. The proposed formulation allows for the definition of CAT bond pricing based on a fixed accepted level of risk. With the proposed formulation, the probability distribution of the CAT bond default probability can be found for a selected price and, conversely, a price can be selected for a given level of desired default risk. The proposed theory is illustrated with a numerical example.