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Addressing the financial impact of natural disasters in the era of climate change

Author

Listed:
  • Bufalo, Michele
  • Ceci, Claudia
  • Orlando, Giuseppe

Abstract

The objective of our study is to predict the financial losses that may result from natural disasters, along with their level of volatility, over a period of 1 to 15 years. Volatility can lead to significant fluctuations in Profit and Loss (P&L) for companies that are affected by unexpected events. To achieve this goal, we created a novel two-factor square-root model that allows us to establish a correlation between the frequency of occurrences and volatility, using correlated Brownian motions. Moreover, we utilized a Generalized Pareto Distribution (GPD) to estimate the maximum potential loss in terms of Value at Risk (VaR) for each specific type of natural disaster. To ensure the reliability of our predictions, we compared our results to those of four reference models and conducted a backtesting analysis. This approach is particularly suitable for insurance companies seeking to maintain stable reserves, but it can also be adapted for any other type of business that is vulnerable to extreme events and aims to safeguard a consistent cash flow for their stakeholders.

Suggested Citation

  • Bufalo, Michele & Ceci, Claudia & Orlando, Giuseppe, 2024. "Addressing the financial impact of natural disasters in the era of climate change," The North American Journal of Economics and Finance, Elsevier, vol. 73(C).
    • Handle: RePEc:eee:ecofin:v:73:y:2024:i:c:s1062940824000779
    DOI: 10.1016/j.najef.2024.102152
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    More about this item

    Keywords

    Forecasting; Natural disasters; Two-factor square-root model; Generalized Pareto distribution; Model validation;
    All these keywords.

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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