CAT Bonds Research Articles

Insurance Options: Beating the benchmark. Are Catastrophe Bonds more profitable than Corporate Bonds?

In this paper we establish a comparison between one of the most traded financial derivatives in the markets, the so-called catastrophe bonds (abbreviated as cat bonds) and the corporate bonds. In the first section, we start from a brief definition as well as some basic concepts. In section two, we will enumerate the type of investors to whom these products might interesting and how to price them. Afterwards, in section three we move onto the analysis of the trading rule proposed, that is, the comparison with Corporate bonds, our benchmark, in terms of expected returns. In sections four and five, we will point out some key issues on how the credit risk associated to these products can be reduced and, finally, in the last section, we will conclude with some discussions and remark the state-of-the-art research on this field.

Risk-based catastrophe bond design for a spatially distributed portfolio

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. Despite their growing importance, connected with the higher exposures to potential natural disasters, relatively few studies on CAT bond pricing, design and their application are available in the literature. In particular, the existing pricing formulations for pricing analysis do not account for uncertainties in model parameters and are not contextualized in a more general CAT bond coverage design procedure for an area of interest. For these reasons, this paper presents a general procedure for designing a CAT bond-based coverage for a spatially distributed portfolio against losses due to natural hazards, accounting also for model parameters uncertainties in CAT bond pricing process. The procedure is then applied to a case study represented by the residential building portfolio in Italy, proposing an ad-hoc CAT bond-based coverage against losses induced by earthquake occurrences, defined on the basis of the most recent version of the seismic risk map of Italy currently proposed in scientific literature.

How to Deal with Small Data Sets in Machine Learning: An Analysis on the CAT Bond Market

How to Deal with Small Data Sets in Machine Learning: An Analysis on the CAT Bond Market

Estimation of the Catastrophe Bonds Price by using Risk Neutral Measurement

Catastrophe Bonds (CAT bonds) or disaster bonds are securities products that work by transferring risk in the form of natural disaster losses to the capital market, so that it is necessary to estimate CAT bond prices. This study intends to discuss the model to determine the price of CAT bonds in arbitrage-free scope based on the approach of risk neutral measurement. The data used is extreme data in the form of losses due to natural disasters in the range of 2000-2019. There are several stages carried out in this study. The first step is to calculate descriptive data statistics. Then, estimating the data parameters using the Maximum Likelihood Estimation (MLE) method assuming the data distributed Generalized Extreme Value (GEV). Next, determine the price of CAT bond using the formula of risk neutral measurement. From the results of the analysis carried out, the CAT bond price is USD98.63, and there is the effect of risk neutral measurement on the price of CAT bonds paid by investors.

The diffusion of complex securities: The case of CAT bonds

Complex securities generally do not diffuse smoothly but by fits and starts in response to sudden shifts in demand, occurring as investors learn about the intrinsic value of the securities from their noisy performance. We use CAT bonds, a capital market-based alternative to CAT risk reinsurance, to illustrate the diffusion of a complex security that competes against a legacy financial product offered by financial intermediaries. We find that the diffusion of the security is highly path-dependent with the capricious ups and downs of its actual performance plus the competitive response of CAT reinsurers jointly determining its ultimate success or failure.

Risk-based CAT bond pricing considering parameter uncertainties

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.

Risk transfer and moral hazard: An examination on the market for insurance-linked securities

Abstract Insurance-linked securities provide capital market-based insurance against the risk of natural catastrophes. A challenge arising with the use of those instruments is their sponsor’s potential susceptibility towards moral hazard, which has not been studied in the empirical literature. This study examines whether the sponsors of CAT bonds with indemnity trigger – the currently most prominent type of insurance-linked security – are susceptible to ex-ante moral hazard (i.e., before the occurrence of a catastrophic event) and ex-post moral hazard (i.e., after a catastrophic event). Therefore, we apply panel regression and matching techniques to a comprehensive data set comprising US insurers’ annual statements and information on their activities as CAT bond sponsors. We propose a novel approach to measure moral hazard using the insurers’ loss adjustment expenses. Controlling for the unobserved heterogeneity and time-variant insurer characteristics, we find that sponsors using CAT bonds with indemnity trigger are susceptible to ex-ante moral hazard, but not affected by ex-post moral hazard. We further show that vertical loss retention has a positive effect on sponsors’ incentives to contain losses.

Reinsurance or Cat Bond? How to Optimally Combine Both

Hardle and Cabrera (2010) show empirically that a mix of reinsurance and CAT bond provides a catastrophe insurer with coverage at a lower cost and lower exposure at default than reinsurance alone. To underpin theoretically this empirical finding, we develop a model to optimally combine reinsurance and CAT bonds. We use a contingent claims framework to show that it is optimal to cover small losses using reinsurance and hedge higher losses by issuing a CAT bond. Our results demonstrate that this strategy significantly lowers the insurer’s cost of protection, expands his underwriting capacity and yields higher shareholder values.

Climate change implications for the catastrophe bonds market: An empirical analysis

Since their introduction in the mid-1990s, the return per unit of risk or multiple on catastrophe (cat) bonds has steadily declined. This paper investigates whether this pattern is consistent with the historical evolution of natural disaster risk, using average multiple figures over the period 1997–2017. Assessing the accuracy of cat bond pricing is important, since about 50% of outstanding risk capital in the cat bonds market is currently exposed to Atlantic hurricanes -a risk that global warming, among other disruptions, is found to enhance- and pension and mutual funds in European and other OECD countries currently own about 30% of the market. In this respect, while our findings suggest that falling multiples are primarily related to the Fed's expansionary monetary stance and to portfolio shift effects, we do also find evidence of significant undervaluation of global warming risk in the cat bonds market. This finding, also in light of the unfailing appetite of institutional investors for such securities, casts doubts over the sanity of the market and over cat bonds as suitable investment products for risk averse investors. Sounder investment opportunities might be found in the green bonds market, which allows for the funding of immediate investment in climate change mitigation too.

A Candidate Proxy to be used in Intensity-Based Triggering Mechanism for Parametric CAT-Bond Insurance: Istanbul Case Study

We study the suitability of average peak ground acceleration ( PGA) as a ground-motion proxy for parametric catastrophe bond (CAT bond) design. We tie the selection of PGA (as a triggering parameter for CAT bonds) to computational convenience (fast retrieval from the recorded ground motion) and loss correlation (optimum monetary return on the investor side). Our case studies advocate that PGA, as a candidate ground-motion proxy, can be used confidently for parametric CAT bonds, particularly applications associated with dense coverage of seismic networks. It is still a compelling ground-motion proxy even if the seismic network coverage is sparse, provided that the accelerometric stations are deployed in the vicinity of assets that financially represent the most significant portion of the insured building stock. We establish an event-based risk model of the Istanbul city (via Monte Carlo simulations) to depict the rationale behind our proposition and compare its performance with other competing (more sophisticated) proxies in terms of accelerometric network density and spatial distribution as well as the different risk levels used in risk management.

The Role of CAT Bonds in an International Multi-Asset Portfolio: Diversifier, Hedge, or Safe Haven?

We examine whether CAT bonds can serve as a hedge or a safe haven for global stock, bond, real estate, commodity, private equity, and infrastructure markets. Our results indicate that CAT bonds are a poor hedge, but they act as an effective diversifier against all asset classes under investigation. Moreover, CAT bonds can serve as a strong safe haven against extreme price drops of stocks only during the post-crisis period.

Common feline problem behaviors: Urine spraying

Urine spraying (synonymous terms include urine marking or scent marking) is commonly described as urine deposited on vertical surfaces while the cat is in a standing position. With the increasing trend of keeping cats indoors in some countries and the potential resultant increase in frustration-related behaviors, urine spraying may occur in the home. Although also a normal feline behavior, it is usually not deemed acceptable when the cat targets household possessions. Urine spraying is a common behavioral complaint that practitioners receive from cat owners and has the potential to disrupt the human-cat bond. In fact, feline elimination issues are a frequent reason cited by owners when they relinquish their cats to shelters and rescue organizations. While the location of the deposited urine should be diagnostic, this is not always the case. Urine marking can occur on horizontal surfaces, thus complicating the diagnosis. Urine spraying by intact males and females is used to signal availability for mating but the behaviour can also be exhibited by neutered animals. Multiple factors including medical problems can trigger the onset and maintenance of urine spraying, and correct identification of these is necessary for treatment to be most successful. This review draws on information from multiple studies that have been published on the normal aspects of urine spraying in cats, the frequency as reported by owners, the relationship of urine spraying to intercat aggression and various treatment options including behavior modification, pheromone therapy and use of psychoactive medication.

A general class of distortion operators for pricing contingent claims with applications to CAT bonds

ABSTRACTThe current paper provides a general approach to construct distortion operators that can price financial and insurance risks. Our approach generalizes the (Wang 2000) transform and recovers multiple distortions proposed in the literature as particular cases. This approach enables designing distortions that are consistent with various pricing principles used in finance and insurance such as no-arbitrage models, equilibrium models and actuarial premium calculation principles. Such distortions allow for the incorporation of risk-aversion, distribution features (e.g. skewness and kurtosis) and other considerations that are relevant to price contingent claims. The pricing performance of multiple distortions obtained through our approach is assessed on CAT bonds data. The current paper is the first to provide evidence that jump-diffusion models are appropriate for CAT bonds pricing, and that natural disaster aversion impacts empirical prices. A simpler distortion based on a distribution mixture is finally proposed for CAT bonds pricing to facilitate the implementation.

Catastrophe bond spread and hurricane arrival frequency

Catastrophe bonds are the most successful alternative risk transfer tools in transferring catastrophic insurance risk to capital markets. This research provides empirical insights about the predictive power of catastrophe bond spreads in forecasting catastrophe arrival frequency as a test of the catastrophe bond market’s price discovery efficacy. Primary-market data for cat bonds, catastrophe arrival frequency data for hurricanes and windstorms, and climate variable data for Atlantic Multidecadal Oscillation, North Atlantic Oscillation and CO2 change rate are collected over June 1997 to March 2013 to examine this power. The calibration results show that cat bond spreads convey valuable incremental information as measured by the Akaike Information Criterion. Furthermore, in an out-sample test for hurricanes prediction, merging the conventional climate variables approach with our market-based forward-looking predictions reduces prediction errors by about 3% over the sample period. As the catastrophe bond market continues to grow with increasing trading volume, a needed ingredient to enhance market efficiency, we would expect this measure of improvement to accentuate.

Diversification Benefits of Cat Bonds: An In-Depth Examination

We investigate whether the inclusion of Cat Bonds in portfolios composed of traditional assets and common factors is beneficial to investors. Various mean‐variance spanning tests performed for the period of 2002 to 2017 show that under different market conditions, the addition of Cat Bonds gives rise to previously unattainable portfolios. Using the Engle (2002) Dynamic Conditional Correlation (DCC) model, we find that including Cat bonds increases significantly the time‐varying Sharpe ratio and the Choueifaty and Coignard (2008) maximum diversification ratio. Cat Bonds provide needed diversification during critical times particularly during episodes of crisis and of high volatility. Under the second‐order stochastic dominance efficiency (SDE) tests, the null hypothesis that portfolios without Cat Bonds are efficient cannot be rejected. Out‐of‐sample analyses indicate that the performance of portfolios with Cat Bonds included varies depending on the performance measures employed, the portfolio construction techniques used and the assets or factors considered.

Seasonality in Catastrophe Bonds

Catastrophe bonds are securities that transfer catastrophe risk from sponsors, which are mostly (re-)insurance companies, to capital markets. Based on secondary market data from 386 seasonality-affected cat bonds, we employ fixed effects regression models to explain seasonality in cat bond spreads. First, we show that the impact of seasonality on spreads depends on fluctuating arrival frequencies, the magnitude of the expected loss and the maturity of the cat bond. Second, we use modeled distributions of arrival frequencies of qualifying events to construct a measure of cat bond seasonality that captures these three effects. Up to 47% of all secondary market fluctuation in single-peril hurricane bonds can be explained through this seasonality measure. Third, we establish a method to deduct market-implied distributions of arrival frequencies from secondary market spreads, reflecting a market-based assessment of catastrophe arrival frequencies.

An Empirical Assessment of the Impact of Insurance Premiums in the Face of Catastrophic Losses As Well As Cost of Capital

The issues regarding catastrophic losses is quite an important factor to consider in the course of insurance and the issuance of CAT bonds. This not withstanding the issue of cost of capital is quite undeniable should an assessment of this magnitude be done. Researchers have indicated that catastrophic losses are independent whereas cost of capital is relative to the standard deviation of losses to time periods. We then by this paper do an empirical assessment of independence of losses to time and employ Modigliani-Miller theorem to assess the cost of capital. We further look at the variations of the expected and realized losses and based on that employ the Bayesian updated serial correlation module and assess its impacts on insurance premiums.

An Empirical Review of Basis Risk Assessment of Triggers i.e. Index, Model-Based and the Hybrid Triggers in Lieu of Individual and Industry Losses

The absolute value of the distinguishing factor that exist between losses employed in triggering the occurrences of CAT bonds and the exact losses for an insurer is considered Basis Risk. This kind of risk is not only related to insurers only but also CAT bond investors as well. This is because both parties somewhat may suffer from the loss of basis risk. It is noteworthy that Basis risk could be considered a zero-sum game for both counterparties i.e. investors and insurers respectively when there is a trade in of CAT bonds.

Sponsor- and trigger-specific determinants of CAT bond premia: a summary

This manuscript employs a broad set of CAT bond secondary market data to investigate the influence of sponsor characteristics and alternative trigger mechanisms on the CAT bond premium. We show that a CAT bond sponsor’s diversification, his rating as well as his vertical integration are significant factors affecting CAT bond premia. Furthermore, our findings suggest that investors demand higher premia for CAT bonds with indemnity trigger. The contribution is a short summary of a working paper presented at the annual meeting of the German Insurance Science Association (DVfVW) in Munich in March 2018.

Pricing Dynamics in the Market for Catastrophe Bonds

In this paper we study the time variation of the market price of Catastrophe bonds for the period 1999-2016. While we find an overall decreasing trend in the expected loss premium, large catastrophes increase the expected loss premium by an order of 20% on average. Our empirical tests show that the latter effect is temporary and unlikely to be caused by behavioral changes in investors’ perceptions about catastrophic risk as previously documented. Instead, we find evidence that the changes in expected loss premiums are explained by changes in investor effective risk aversion, initiated by investors reaching habit consumption levels when a catastrophic event triggers Cat bond losses. Contagion effects from the reinsurance markets are more relevant after main catastrophes given the levels of liquidity in the markets. Furthermore, contagion effects from financial markets are minor and only relevant during the subprime financial crisis.