HURRICANE RISK MANAGEMENT WITH CLIMATEAND CO₂ INDICES

Abstract

We propose a regime-switching Poisson process incorporating climate and carbon dioxide (CO 2 ) indices (RPCM) to model hurricane frequency. Model accuracy shows that two-state RPCM (2-RPCM) is superior to the existing climate methods, as forecast errors under 2-RPCM are smaller than previous models by about 60-75 percent. We derive the pricing formula of reinsurance premiums by assuming the aggregate loss following the regime-switching compound process. Pricing errors under 2-RPCM for reinsurance premiums are 35-54 percent lower than those from previous models. The climate and regime-switching effects dominate the CO 2 effect in reducing pricing errors and producing more effective tail value at risk.Based only on CAT loss data, insurance economists employ a pure Poisson process to describe the frequency of CAT events to price CAT insurance products (e.g.