Designing catastrophic bonds for catastrophic risks in agriculture

Abstract

Purpose -The purpose of this paper is to outline a pricing formula for the valuation of catastrophic (CAT) bonds as applied to multiple trigger drought risks in Kenya. Design/methodology/approach -The valuation model is designed around the multiple triggers of the Mexican Catastrophe bonds, but the valuation model is based on Jarrow's (2010) closed form CAT Bond Pricing model. The authors outline the model structure, the multiple tranches with rainfall triggers, and simulate the model using Monte Carlo methods. Data input was synthesized from historical rainfall data in Kenya's Moyale region as well as prevailing LIBOR and rates and conventional coupons. Findings -The authors compute the valuation model using Monte Carlo techniques. The authors found the pricing method to be robust and consistent under various parameter settings including trigger levels, time after launch, recovery rates, coupon spreads, and zero coupon curves. For example the higher the trigger rates, the lower will be the bond price at issue. With 50 percent recovery the CAT bond at issue would be around $702 with a high triggers and 976 with low triggers, but the valuation changes with parameters. Practical implications -As far as the authors know the use of multiple trigger CAT bonds has been very limited in practice. The valuation formula and methods outlined in this paper show how CAT bonds can be effectively designed to address CAT covariate risks in developing agricultural economies. Originality/value -This paper examines CAT bonds to investigate multi-trigger rainfall risks in Kenya. The paper shows how CAT bonds can be designed to meet specific and CAT risks. Using Jarrow's (2010) closed form solution this paper is one of the first to apply it to the macro-management of agricultural risks.

Application of Compound Poisson Process in Pricing Catastrophe Bonds: A Systematic Literature Review

“…Homogeneous 17 [3,9,[19][20][21][22]25,[27][28][29][30][31][32][33][34][35][36] Nonhomogeneous 13 [23,24,26,[37][38][39][40][41][42][43][44][45][46] Table 3 shows that homogeneous CPP is more widely used in pricing CAT bonds than nonhomogeneous CPP. The catastrophe intensity is not always constant in every unit of time, but homogeneous CPP is the most widely used.…”

“…Thus, of the 30 existing models, these models generally do not have a closed-shaped solution. For models that have a closed-form solution, the authors are Jarrow [23], Sun et al [40], Georgiopoulos [32], Tang and Yuan [36], and Deng et al [9]. They do not require an alternative method to obtain the solution because this can be determined by common arithmetic operations, whereas models that do not have a closed-form solution must use an alternative method to determine the solution.…”

Modeling Multiple-Event Catastrophe Bond Prices Involving the Trigger Event Correlation, Interest, and Inflation Rates

“…The model considered losses, fatalities, stochastic interest rates, and trigger event correlation rates and was designed using a representative agent pricing model and copula. Then, Sun et al [18] introduced the drought MECB pricing model by considering the long-term and short-term rainfall and the stochasticity of interest rates. This model is a development of the Jarrow model with an addition of more triggers.…”

“…Table 1 shows that the trigger event indices commonly used in designing MECB pricing frameworks in previous studies are the loss and fatality indices, where three out of five used them. Only Sun et al [18] and Wei et al [21] used long-term and short-term rainfall indices and magnitude and loss indices, respectively. Then, the primary methods used vary.…”

Using a regional climate model to develop index-based drought insurance for sovereign disaster risk transfer

“…Governments have increasingly been using macro-level risk transfer products to cover public infrastructure from earthquakes and hurricanes through insurance-linked securities such as catastrophe bonds (Linnerooth-Bayer and Hochrainer-Stigler, 2015). The use of a catastrophe bond for agricultural risks has theoretically been discussed for a state-wide reduction in cotton yields in Georgia, USA (Vedenov et al, 2006) and for drought risk in Kenya (Sun et al, 2015). Despite its potential, only a few macro-level insurance structures have been implemented for sovereign risks in agriculture.…”