Pricing Zero-Coupon Catastrophe Bonds Using EVT with Doubly Stochastic Poisson Arrivals

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Abstract
The frequency and severity of climate abnormal change displays an irregular upward cycle as global warming intensifies. Therefore, this paper employs a doubly stochastic Poisson process with Black Derman Toy (BDT) intensity to describe the catastrophic characteristics. By using the Property Claim Services (PCS) loss index data from 2001 to 2010 provided by the US Insurance Services Office (ISO), the empirical result reveals that the BDT arrival rate process is superior to the nonhomogeneous Poisson and lognormal intensity process due to its smaller RMSE, MAE, MRPE, and U and larger E and d. Secondly, to depict extreme features of catastrophic risks, this paper adopts the Peak Over Threshold (POT) in extreme value theory (EVT) to characterize the tail characteristics of catastrophic loss distribution. And then the loss distribution is analyzed and assessed using a quantile-quantile (QQ) plot to visually check whether the PCS index observations meet the generalized Pareto distribution (GPD) assumption. Furthermore, this paper derives a pricing formula for zero-coupon catastrophe bonds with a stochastic interest rate environment and aggregate losses generated by a compound doubly stochastic Poisson process under the forward measure. Finally, simulation results verify pricing model predictions and show how catastrophic risks and interest rate risk affect the prices of zero-coupon catastrophe bonds.
Funding Information
  • Ministry of Education of the People’s Republic of China (15YJC790074, 2014A030310305, 71273066, 71431008, 71573056, 71603058, 71521061)
  • Natural Science Foundation of Guangdong Province (15YJC790074, 2014A030310305, 71273066, 71431008, 71573056, 71603058, 71521061)
  • National Natural Science Foundation of China (15YJC790074, 2014A030310305, 71273066, 71431008, 71573056, 71603058, 71521061)
  • National Natural Science Foundation of China (15YJC790074, 2014A030310305, 71273066, 71431008, 71573056, 71603058, 71521061)
  • National Natural Science Foundation of China (15YJC790074, 2014A030310305, 71273066, 71431008, 71573056, 71603058, 71521061)
  • National Natural Science Foundation of China (15YJC790074, 2014A030310305, 71273066, 71431008, 71573056, 71603058, 71521061)
  • National Natural Science Innovation Research Group of China (15YJC790074, 2014A030310305, 71273066, 71431008, 71573056, 71603058, 71521061)

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