Modeling the Price Dynamics of Catastrophe Bonds

Catastrophe bonds, whose payoffs to investors are tied to the occurrence of natural disasters, provide primary insurers and reinsurers a mechanism by which they can securitize and transfer some of their residual risk to capital markets. We note that catastrophe bonds can be very attractive to investors as they provide the unique opportunity to improve a portfolio managers allocation by offering them an instrument that has both an attractive return and low covariability with financial markets. While catastrophe bonds are theoretically attractive, they have remained marginal relative to tranditional reinsurance. This paper proposes that a possible explanation for this marginality can be attributed to the lack of discussion about the pricing and valuation of these instruments in a public forum. We hope that this paper, which draws parallels between the modeling of defaultable bonds in a reduced-form setting and the pricing of catastrophe bonds, can serve as a springboard for future research in the insurance linked securities space.