Pricing of catastrophe bonds

Abstract

Catastrophe (CAT) bonds are one of the more recent financial derivatives to be traded on the world markets. In the mid-1990s a market in catastrophe insurance risk emerged in order to facilitate the direct transfer of reinsurance risk associated with natural catastrophes from corporations, insurers and reinsurers to capital market investors. The primary instrument developed for this purpose was the CAT bond. CAT bonds are more specifically referred to as insurance-linked securities (ILS) The distinguishing feature of these bonds is that the ultimate repayment of principal depends on the outcome of an insured event. The basic CAT bond structure can be summarized as follows (Lane, 2004): 1. The sponsor establishes a special purpose vehicle (SPV) as an issuer of bonds and as a source of reinsurance protection. 2. The issuer sells bonds to investors. The proceeds from the sale are invested in a collateral account. 3. The sponsor pays a premium to the issuer; this and the investment of bond proceeds are a source of interest paid to investors. 4. If the specified catastrophic risk is triggered, the funds are withdrawn from the collateral account and paid to the sponsor; at maturity, the remaining principal - or if there is no event, 100% of principal - is paid to investors.There are three types of ILS triggers: indemnity, index and parametric. An indemnity trigger involves the actual losses of the bond-issuing insurer. For example the event may be the insurer's losses from an earthquake in a certain area of a given country over the period of the bond. An industry index trigger involves, in the US for example, an index created from property claim service (PCS) loss estimates. A parametric trigger is based on, for example, the Richter scale readings of the magnitude of an earthquake at specified data stations. In this chapter we address the issue of pricing CAT bonds with indemnity and index triggers. © Springer-Verlag Berlin Heidelberg 2005.