Pricing Dynamics in the Market for Catastrophe Bonds

Abstract

In this paper we study the time variation of the market price of Catastrophe bonds for the period 1999-2016. While we find an overall decreasing trend in the expected loss premium, large catastrophes increase the expected loss premium by an order of 20% on average. Our empirical tests show that the latter effect is temporary and unlikely to be caused by behavioral changes in investors’ perceptions about catastrophic risk as previously documented. Instead, we find evidence that the changes in expected loss premiums are explained by changes in investor effective risk aversion, initiated by investors reaching habit consumption levels when a catastrophic event triggers Cat bond losses. Contagion effects from the reinsurance markets are more relevant after main catastrophes given the levels of liquidity in the markets. Furthermore, contagion effects from financial markets are minor and only relevant during the subprime financial crisis.

Keywords: Cat Bonds, Insurance, Habit, Catastrophe