MANAGING CATASTROPHIC RISK BY ALTERNATIVE RISK TRANSFER INSTRUMENTS

Chapter 1 analyzes hybrid-trigger CAT bonds, a new CAT bond deal that can reduce basis risk and eliminate moral hazard simultaneously. It is the first research that provides analytical evidence on the condition under which the hybrid trigger has lower basis risk. Simulation results support my analyses. Major findings in this study provide insights to insurers who would proactively manage the basis risk of CAT bonds. Chapter 2 examines whether the parimutuel mechanism can hedge risk-averse people against catastrophic losses. Two optimal stake choice models are constructed. In the first model where the stakes of other players are exogenous, the optimal stake can be obtained by equating the marginal cost of a net payoff with the ratio of the expected marginal utilities in the payoff state and the no payoff state. The dynamic optimal hedge can be achieved if the odds, and the conditional probability of a hurricane hitting the target area, are available. In the second model, an optimal equilibrium stake is derived by maximizing the representative agent’s expected utility. Given no transaction fee and tax, we show that parimutuel insurance intrinsically leads to participants being underinsured due to basis risk. Although participants will be underinsured, parimutuel insurance guarantees no underlying risk borne by the issuer. We also derive the equivalent transaction costs of traditional insurance relative to HuRLOs. The actual transaction cost for traditional insurance is found to be higher than the equivalent utility level implied by HuRLOs, suggesting that hedgers would be better off with HuRLOs than with traditional insurance. Chapter 3 analyzes the implications of climate change for catastrophic risk and examines the appropriateness of longer term insurance contracts to protect insurers against catastrophic losses and changes in risk estimates over time. Climate change essentially plays an important role in modeling catastrophic risks, especially in the tail of the loss distribution and for longer time scales. Mitigations can completely offset the impact of climate change. Longer term insurance contract may stimulate the incentive to invest on mitigation; however, risk capital required and annual premiums could increase significantly due to the additional premium risk faced by the insurers.