CAT BOND PRICING UNDER A PRODUCT PROBABILITY MEASURE WITH POT RISK CHARACTERIZATION

Abstract

AbstractFrequent large losses from recent catastrophes have caused great concerns among insurers/reinsurers, who then turn to seek mitigations of such catastrophe risks by issuing catastrophe (CAT) bonds and thereby transferring the risks to the bond market. Whereas, the pricing of CAT bonds remains a challenging task, mainly due to the facts that the CAT bond market is incomplete and that the pricing usually requires knowledge about the tail of the risks. In this paper, we propose a general pricing framework based on a product pricing measure, which combines a distorted probability measure that prices the catastrophe risks underlying the CAT bond with a risk-neutral probability measure that prices interest rate risk. We also demonstrate the use of the peaks over threshold (POT) method to uncover the tail risk. Finally, we conduct case studies using Mexico and California earthquake data to demonstrate the applicability of our pricing framework.