Market-Implied Spread for Earthquake CAT Bonds: Financial Implications of Engineering Decisions

Abstract

In the event of natural and man-made disasters, owners of large-scale infrastructure facilities (assets) need contingency plans to effectively restore the operations within the acceptable timescales. Traditionally, the insurance sector provides the coverage against potential losses. However, there are many problems associated with this traditional approach to risk transfer including counterparty risk and litigation. Recently, a number of innovative risk mitigation methods, termed alternative risk transfer (ART) methods, have been introduced to address these problems. One of the most important ART methods is catastrophe (CAT) bonds. The objective of this article is to develop an integrative model that links engineering design parameters with financial indicators including spread and bond rating. The developed framework is based on a four-step structural loss model and transformed survival model to determine expected excess returns. We illustrate the framework for a seismically designed bridge using two unique CAT bond contracts. The results show a nonlinear relationship between engineering design parameters and market-implied spread. © 2010 Society for Risk Analysis.