Loss modeling for pricing catastrophic bonds



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It is important to be able to quantify potential seismic damage to structures and communicate risk in a comprehendible way to all stakeholders. The risks involved with damage to constructed facilities due to catastrophic disasters can be hedged using financial instruments such as Catastrophic (CAT) bonds. This work uses the loss ratio (Lr), which is the ratio of the repair cost to the total replacement cost, to represent structural and non-structural damage caused by earthquakes. A loss estimation framework is presented that directly relates seismic hazard to seismic response to damage and hence to losses. A key feature of the loss estimation approach is the determination of losses without the need for fragility curves. A Performance-Based Earthquake Engineering (PBEE) approach towards assessing the seismic vulnerability of structures relating an intensity measure (IM) to its associated engineering demand parameter (EDP) is used to define the demand model. An empirically calibrated tripartite loss model in the form of a power curve with upper and lower cut-offs is developed and used in conjunction with the previously defined demand model in order to estimate loss ratios. The loss model is calibrated and validated for different types of bridges and buildings. Loss ratios for various damage states take into account epistemic uncertainty as well as an effect for price surge following a major hazardous event. The loss model is then transformed to provide a composite seismic hazard-loss relationship which is used to estimate financial losses from expected structural losses. The seismic hazard-loss model is then used to assess the expected spread, that is the interest rate deviation above the risk-free (prime) rate in order to price two types of CAT bonds: indemnity CAT bonds and parametric CAT bonds. It is concluded that CAT bonds has the ability to play a major role in hedging financial risk associated with damage to a civil engineering facility as a result of a catastrophe. However, it is seen that a potential investor seeks a high degree of confidence when investing in CAT bonds as there is huge uncertainty surrounding the probability of occurrence of an event.