The underlying assumptions for pricing catastrophe bonds, reinsurance and industry loss warranties (ILWs) is likely flawed and underpricing the risk in many contracts, according recently released research.
Current market practices of applying the classic Black–Scholes–Merton options model to catastrophe risk — along with its reliance on comparing risks over a “continuous time” — does not capture the underlying natural hazards risk in many traditional catastrophe instruments and derivatives, according to a paper published by two researcher’s from Concordia University in Quebec, Canada.
As part of the study, the paper uses a “notional reinsurance contract on hurricane wind damage in the state of Florida” to prove its point.
“We show that the Merton price lies far below our bounds for almost all realistic values of the hurricane futures contract parameter, expressed as a multiple of the expected intensity of the CAT event,” the research says. “We also show [the] pitfalls of neglecting or minimizing the importance of the CAT event systematic risk.”
According to the thesis, the underlying problem is that traders and banks in the cat risk market are using traditional options pricing methodology. As a result, investors and other market participants are not taking into account the fact that the primary issuers of the risk — insurance companies — “specialize locally and in special types of CAT risks” that cancel out the usefulness of the Black–Scholes–Merton model for pricing.
“Unlike most studies on such derivatives this method does not assume that the CAT event risk can be diversified away,” the research states. “We show that the Merton price lies far below our bounds for almost all realistic values of the hurricane futures contract parameter, expressed as a multiple of the expected intensity of the CAT event.”
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