Elements of Risk Mitigation for Catastrophe Bond Derivatives
The re-insurance industry is undergoing a remarkable transformation, as increasing numbers of "catastrophe bonds" are structured to help monetize and distribute a diverse set of risks to a capital markets environment hungry for uncorrelated risk dimensions. In order to accommodate institutional investors' balance-sheet composition constraints, dealers have also begun offering derivatives based on portfolios of cat bonds. After delineating the risk components that these novel instruments introduce, we focus on understanding the diversification effects they can afford.
In order to investigate the dependence of the diversification benefit to the composition of the cat bond derivative, we construct a portfolio optimization problem, based on a series of bilateral bounds for the constituent tail events. We then proceed to examine the sensitivity of our risk diversification analysis to changes in the conditional tail correlation patterns. We close the talk with a brief discussion of the lessons we can draw from our modeling exercise in designing an effective risk management infrastructure around the underwriting and trading of these fashionable and versatile financial instruments.