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Using Catastrophe-Linked Securities to Diversity Insurance Risk: A Financial Analysis of Cat Bonds

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  • Henri Louberge
  • Evis Kellezi
  • Manfred Gilli

Abstract

Severe natural catastrophes in the early 1990s generated a lack of financial capacity in the catastrophe line of the global reinsurance market. The finance industry reacted to this situation by issuing innovative products designed to spread the excess risk more widely among international investors (risk securitization). The paper reviews these developments and emphasizes their significance with respect to the economic theory of risk exchanges. Special attention is devoted to the case of catastrophe- linked bonds, issued by ceding insurers to secure ex post conditional capital for the payment of claims. We analyze these new securities as financial portfolios combining a straight bond and catastrophe options. Using option pricing theory and simulation analysis in a stochastic interest rate environment, we show that investors attracted by the potential for diversification benefits should not overlook the optional features when including these securities in an asset portfolio.

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Bibliographic Info

Article provided by Western Risk and Insurance Association in its journal Journal of Insurance Issues.

Volume (Year): 22 (1999)
Issue (Month): 2 ()
Pages: 125-146

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Handle: RePEc:wri:journl:v:22:y:1999:i:2:p:125-146

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Cited by:
  1. Lin, Shih-Kuei & Chang, Chia-Chien & Powers, Michael R., 2009. "The valuation of contingent capital with catastrophe risks," Insurance: Mathematics and Economics, Elsevier, vol. 45(1), pages 65-73, August.
  2. Thorsten Schmidt, 2014. "Catastrophe Insurance Modeled by Shot-Noise Processes," Risks, MDPI, Open Access Journal, vol. 2(1), pages 3-24, February.
  3. Ma, Zong-Gang & Ma, Chao-Qun, 2013. "Pricing catastrophe risk bonds: A mixed approximation method," Insurance: Mathematics and Economics, Elsevier, vol. 52(2), pages 243-254.
  4. Chang, Carolyn W. & Chang, Jack S.K. & Lu, WeLi, 2010. "Pricing catastrophe options with stochastic claim arrival intensity in claim time," Journal of Banking & Finance, Elsevier, vol. 34(1), pages 24-32, January.
  5. Lee, Jin-Ping & Yu, Min-Teh, 2007. "Valuation of catastrophe reinsurance with catastrophe bonds," Insurance: Mathematics and Economics, Elsevier, vol. 41(2), pages 264-278, September.
  6. Lin, X. Sheldon & Wang, Tao, 2009. "Pricing perpetual American catastrophe put options: A penalty function approach," Insurance: Mathematics and Economics, Elsevier, vol. 44(2), pages 287-295, April.
  7. Henri LOUBERGE & Harris SCHLESINGER, 1999. "Optimal Catastrophe Insurance with Multiple Catastrophes," FAME Research Paper Series rp7, International Center for Financial Asset Management and Engineering.
  8. Chang, Carolyn W. & Chang, Jack S.K. & Lu, WeiLi, 2008. "Pricing catastrophe options in discrete operational time," Insurance: Mathematics and Economics, Elsevier, vol. 43(3), pages 422-430, December.
  9. Lo, Chien-Ling & Lee, Jin-Ping & Yu, Min-Teh, 2013. "Valuation of insurers’ contingent capital with counterparty risk and price endogeneity," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5025-5035.

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