Extremal Analysis of Flooding Risk and Its Catastrophe Bond Pricing

Abstract

Catastrophic losses induced by natural disasters are receiving growing attention because of the severe increases in their magnitude and frequency. We first investigated the extreme tail behavior of flood-caused economic losses and maximum point precipitation based on the peaks-over-threshold method and point process (PP) model and its extreme tail dependence. We found that both maximum point precipitation and direct economic losses are well-modeled by the PP approach with certain tail dependence. These findings were further utilized to design a layered compensation insurance scheme using estimated value-at-risk (VaR) and conditional VaR (CVaR) among all stakeholders. To diversify the higher level of losses due to extreme precipitation, we designed a coupon paying catastrophe bond triggered by hierarchical maximum point precipitation level, based on the mild assumption on the independence between flood-caused risk and financial risk. The pricing sensitivity was quantitatively analyzed in terms of the tail risk of the flood disaster and the distortion magnitude and the market risk in Wang’s transform. Our trigger process was carefully designed using a compound Poisson process, modeling both the frequency and the layered intensity of flood disasters. Lastly, regulations and practical suggestions are provided regarding the flood risk prevention and warning.

Keywords

• extreme value theory
• peaks-over-threshold
• CAT bond
• point process
• Vasicek model
• tail dependence