Pricing catastrophe swaps: A contingent claims approach

Alexander Braun

Insurance: Mathematics and Economics, 2011, vol. 49, issue 3, 520-536

Abstract: In this paper, we comprehensively analyze the catastrophe (cat) swap, a financial instrument which has attracted little scholarly attention to date. We begin with a discussion of the typical contract design, the current state of the market, as well as major areas of application. Subsequently, a two-stage contingent claims pricing approach is proposed, which distinguishes between the main risk drivers ex-ante as well as during the loss reestimation phase and additionally incorporates counterparty default risk. Catastrophe occurrence is modeled as a doubly stochastic Poisson process (Cox process) with mean-reverting Ornstein–Uhlenbeck intensity. In addition, we fit various parametric distributions to normalized historical loss data for hurricanes and earthquakes in the US and find the heavy-tailed Burr distribution to be the most adequate representation for loss severities. Applying our pricing model to market quotes for hurricane and earthquake contracts, we derive implied Poisson intensities which are subsequently condensed into a common factor for each peril by means of exploratory factor analysis. Further examining the resulting factor scores, we show that a first order autoregressive process provides a good fit. Hence, its continuous-time limit, the Ornstein–Uhlenbeck process should be well suited to represent the dynamics of the Poisson intensity in a cat swap pricing model.

Keywords: Catastrophe swaps; Contingent claims pricing approach; Doubly stochastic Poisson process; Mean-reverting Ornstein–Uhlenbeck intensity; Counterparty default risk; Implied intensities; Exploratory factor analysis; First order autoregressive process (search for similar items in EconPapers)
JEL-codes: G1 G13 G2 G22 (search for similar items in EconPapers)
Date: 2011
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (27)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0167668711000849
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:49:y:2011:i:3:p:520-536

DOI: 10.1016/j.insmatheco.2011.08.003

Access Statistics for this article

Insurance: Mathematics and Economics is currently edited by R. Kaas, Hansjoerg Albrecher, M. J. Goovaerts and E. S. W. Shiu

More articles in Insurance: Mathematics and Economics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().