CAT bond pricing and coverage design against natural perils

Catastrophe (CAT) bonds are risk-linked securities used by the insurance industry to transfer risk associated with the occurrence of natural disasters to the capital market. Despite their growing importance, relatively few studies on CAT bond pricing, design and application are available in the literature. Current state-of-the-art on CAT bonds has some limitations. In particular, the existing pricing formulations do not account for uncertainties in model parameters, and are not contextualized in a more general CAT bond coverage design procedure for an area of interest. The present chapter aims to address these limitations. First, the chapter presents a risk-based CAT bond pricing method that accounts for the uncertainties in the model parameters, and thus leading to a CAT bond price based on a given acceptable level of risk. Second, a more general method designed to transfer catastrophe risks for a given portfolio via the use of CAT bonds is presented. Lastly, a practical application of the proposed CAT bond-based coverage is illustrated considering as case-study of earthquake-induced losses to the residential building portfolio of Italy.