Storm CAT Bond: Modeling and Valuation

Abstract

Both the frequency and intensity of weather-related catastrophes, such as storms and floods, have been increasing due to climate change such as global warming. This leads to rising storm catastrophe risks faced by the property & casualty insurance and reinsurance sector. This research proposes an index-based storm catastrophe (CAT) bond for reinsurers to hedge catastrophe risks related to storm losses. Storm losses data have a large portion of zero values and a continuous positive right-skewed distri- bution, together with high-dimensional spatial dependence. We address these unique properties by proposing a Gamma-two-part-autoregressive (Gamma-2PAR) distribu- tion as the marginal model, and the spatio-temporal vine copula as the dependence model. We investigate the CAT bond market equilibrium and endogenously solve for the optimal market price of risk and coupon rates. Our empirical results using historical losses data at the county-level in Florida show the proposed CAT bond can stabilize the reinsurer’s cash flows and create attractive returns to investors by offering high coupon rates. Our framework can be generalized to design and price other catastrophe financing facilities.