Risk-based catastrophe bond pricing

Catastrophe bonds (CAT bond) are risk-linked securities used by the insurance industry to transfer risks associated with the occurrence of natural disasters to the capital markets (Cummins, 2008). CAT bonds are usually structured as coupon-paying bonds with a default linked to the occurrence of a trigger event. A commonly used trigger event is the overcoming of a loss threshold (Kunreuther and Pauly, 2010). Current formulations for pricing analysis do not account for the uncertainties in the model parameters. However, neglecting such uncertainties might result in assuming risks that are higher than intended. This paper develops a risk-based bond pricing formulation considering the uncertainties in the model parameters. The proposed formulation allows for the definition of CAT bond pricing for a pre-set acceptable level of risk. The proposed theory is illustrated with a numerical example.