Storm CAT Bond: Modeling and Valuation

The frequency and intensity of weather-related catastrophes, such as storms and floods, have been increasing due to climate change. This leads to rising storm catastrophe risks to the property–casualty insurance and reinsurance sector. In this article, we propose an index-based storm catastrophe (CAT) bond for reinsurers to hedge catastrophe risks related to storm losses. Storm loss data have a large portion of zero values and a continuous positive right-skewed distribution, together with high-dimensional spatial dependence. We address these unique properties by proposing a general two-part autoregressive (2PAR) distribution as the marginal model and a semicontinuous spatiotemporal 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 loss data at the county level in Florida show that 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.