An Analysis of the Market Price of Cat Bonds
By Neil M. Bodoff, Yunbo Gan
Existing models of the market price of cat bonds are often too exotic or too simplistic; we present a model that is grounded in theory yet also tractable. We also intend for our analysis of cat bond pricing to shed light on broader issues relating to the theory of risk pricing. By analyzing several years of cat bond prices “when issued,” we describe the market clearing issuance price of cat bonds as a linear function of expected loss, with parameters that vary by peril and zone. The results provide a compact form of describing market prices of cat bonds and thus provide a framework for measuring differences in prices across various perils and zones; the output also allows us to measure changes in the issuance price of cat bonds across different time periods. The results also suggest an overarching theory of risk pricing, in which price of risk depends on two factors: the first factor is the required rate of return on downside risk capital in a portfolio context, and the second factor is the uncertainty of the estimate of the expected loss.
KEYWORDS: Cat bonds, insurance linked securities (ILS), market price of risk, reinsurance, spread, risk pricing, peak, price function