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Pricing Default‐Risky CAT Bonds With Moral Hazard and Basis Risk

Pricing Default‐Risky CAT Bonds With Moral Hazard and Basis Risk Introduction Property‐liability insurance companies traditionally hedge their low‐loss frequency, high‐loss‐severity catastrophe risks by buying catastrophe reinsurance contracts. The traditional reinsurance and catastrophe insurance options, which trade in the Chicago Board of Trade (CBOT), are asset hedge instruments for insurers' or reinsurers' catastrophe risk management. A recent innovation in catastrophe risk management is the catastrophe bond (CAT bond, hereafter). The CAT bond, which is also named as an ``Act of God bond'' or ``insurance‐linked bond,'' is a liability hedge instrument for insurance companies, for which there have been many successful CAT bond issues recently. CAT bond provisions have debt‐forgiveness triggers whose generic design allows for the payment of interest and/or the return of principal forgiveness, and the extent of forgiveness can be total, partial, or scaled to the size of loss. Moreover, the debt forgiveness can be triggered by the insurer's (or reinsurer's) actual losses or on a composite index of insurers' losses during a specific period. The advantage of a CAT bond hedge for (re)insurers (insurers, hereafter) is that the issuer can avoid the credit risk that may arise with traditional reinsurance or catastrophe‐linked options. The CAT bondholders provide the hedge to the insurer by forgiving existing debt. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Risk and Insurance Wiley

Pricing Default‐Risky CAT Bonds With Moral Hazard and Basis Risk

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References (31)

Publisher
Wiley
Copyright
Copyright © 2002 Wiley Subscription Services, Inc., A Wiley Company
ISSN
0022-4367
eISSN
1539-6975
DOI
10.1111/1539-6975.00003
Publisher site
See Article on Publisher Site

Abstract

Introduction Property‐liability insurance companies traditionally hedge their low‐loss frequency, high‐loss‐severity catastrophe risks by buying catastrophe reinsurance contracts. The traditional reinsurance and catastrophe insurance options, which trade in the Chicago Board of Trade (CBOT), are asset hedge instruments for insurers' or reinsurers' catastrophe risk management. A recent innovation in catastrophe risk management is the catastrophe bond (CAT bond, hereafter). The CAT bond, which is also named as an ``Act of God bond'' or ``insurance‐linked bond,'' is a liability hedge instrument for insurance companies, for which there have been many successful CAT bond issues recently. CAT bond provisions have debt‐forgiveness triggers whose generic design allows for the payment of interest and/or the return of principal forgiveness, and the extent of forgiveness can be total, partial, or scaled to the size of loss. Moreover, the debt forgiveness can be triggered by the insurer's (or reinsurer's) actual losses or on a composite index of insurers' losses during a specific period. The advantage of a CAT bond hedge for (re)insurers (insurers, hereafter) is that the issuer can avoid the credit risk that may arise with traditional reinsurance or catastrophe‐linked options. The CAT bondholders provide the hedge to the insurer by forgiving existing debt.

Journal

Journal of Risk and InsuranceWiley

Published: Mar 1, 2002

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