THE IMPACT OF DAMAGE FUNCTIONS USED TO DETERMINE THE CAT BONDS TRIGGER

Seismic risk management is a key factor for reducing the adverse economic impact of devastating earthquakes. Hence,hard and soft measures are needed to be combined effectively to increase resistance and resilience against earthquake disasters. The hard measures include retrofitting and seismic upgrading of existing buildings and construction of safer buildings with improved designs and materials. On the other hand, soft measures can be taken through earthquake insurance and risk transfer security. The fundamental difference between the two methods is that the former reduces the severity of seismic damage physically, while the latter shares the seismic loss with a third-party based on a pre-agreed scheme (Goda, 2015). An earthquake insurance is a contract by which the insurer pledges to pay policyholders (e.g., owners of propertiesand enterprises) in an event of a major destructive earthquake. Insurers also transfer the catastrophe risk to a reinsurer, in order to avoid insolvency, based on a risk-sharing agreement. It should be noted that reinsurers achieve geographical risk diversification through their national/global portfolios. However, due to the huge potential size of the catastrophic earthquakes, it is possible to break the risk-bearing capacity of the insurer and the reinsurer. One of the financial means that reduces the risk of insolvency of insurers and transfers the insurance risk to the capital market (where investors gather financial transactions) is the catastrophe risk (CAT) bonds that provide insurers withsufficient financial reserve to pay claims arising from the destructive event. The mechanism of CAT bonds is that a singlepurpose reinsurer (SPR) issues multi-year bonds to investors and collects funds. In the event of pre-agreed/specified trigger conditions, an SPR releases the principal to the insurer (sponsor) and if the trigger event does not occur until the maturity of bonds, the principal along with profit is paid back to the investors. CAT bonds are more attractive to investors due to higher returns than ordinary securities, and their independence from other financial products in the market. The trigger mechanism, which is considered in this research, is based on the parametric loss estimation in which CAT bonds are triggered when the estimated loss of the event using the parameters that characterize earthquakes is greater than the design loss associated with an exceedance probability. These parameters are determined by a reliable third body (e.g. USGS in United States) after the earthquake.

Keywords:

Catastrophe bonds trigger , Parametric loss estimation , Basis risk , Seismic risk analysis , Earthquake insurance