Pricing catastrophe equity put options: Financial implications of engineering decisions

Natural disasters such as earthquakes, floods, and tsunamis cause large-scale loss of life and result in billions of dollars in damages. However, the global insurance and reinsurance sector only bears a portion of this cost; the majority of the bill is still inflicted on corporations, local communities, and the governments that struggle to recover even years following the disaster. One of the key factors why insurance and reinsurance sectors do not play a more active role is the difficulty in absorbing the losses as well as accurately pricing the underlying risks. This article presents a valuation model for catastrophe equity puts (CatEPuts), an alternative method of risk transfer. The proposed valuation model is based on a four-step engineering loss model to compute the fair value of the CatEPut for different hazard intensities and structural responses. The results from test examples show that such a model can provide a necessary link between the engineering characteristics of the underlying physical assets and the fair value of the CatEPut.