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Pricing catastrophe swaps: A contingent claims approach

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  • Braun, Alexander
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    Abstract

    In this paper, we comprehensively analyze the catastrophe (cat) swap, a financial instrument which has attracted little scholarly attention to date. We begin with a discussion of the typical contract design, the current state of the market, as well as major areas of application. Subsequently, a two-stage contingent claims pricing approach is proposed, which distinguishes between the main risk drivers ex-ante as well as during the loss reestimation phase and additionally incorporates counterparty default risk. Catastrophe occurrence is modeled as a doubly stochastic Poisson process (Cox process) with mean-reverting Ornstein–Uhlenbeck intensity. In addition, we fit various parametric distributions to normalized historical loss data for hurricanes and earthquakes in the US and find the heavy-tailed Burr distribution to be the most adequate representation for loss severities. Applying our pricing model to market quotes for hurricane and earthquake contracts, we derive implied Poisson intensities which are subsequently condensed into a common factor for each peril by means of exploratory factor analysis. Further examining the resulting factor scores, we show that a first order autoregressive process provides a good fit. Hence, its continuous-time limit, the Ornstein–Uhlenbeck process should be well suited to represent the dynamics of the Poisson intensity in a cat swap pricing model.

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    Bibliographic Info

    Article provided by Elsevier in its journal Insurance: Mathematics and Economics.

    Volume (Year): 49 (2011)
    Issue (Month): 3 ()
    Pages: 520-536

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    Handle: RePEc:eee:insuma:v:49:y:2011:i:3:p:520-536

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    Web page: http://www.elsevier.com/locate/inca/505554

    Related research

    Keywords: Catastrophe swaps; Contingent claims pricing approach; Doubly stochastic Poisson process; Mean-reverting Ornstein–Uhlenbeck intensity; Counterparty default risk; Implied intensities; Exploratory factor analysis; First order autoregressive process;

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