Analysis of Risk Premium Determinants on Cat Bonds

AbstractThis paper presents an analysis of the risk premium determinants on catastrophe bonds (cat bonds). Firstly, from a theoretical point of view, the existing models used for determining the level of risk premiums will be presented through a comparative analysis. Then, through an empirical approach we’ll present our results by taking into consideration cat bonds covering earthquake risk issued during 1999-2012. The first model shows the existing relationship between the expected losses of the company that requires coverage through an alternative risk transfer instrument such as cat bonds and the level of risk premium. By estimating our model in different conditions, taking as parameters the location and the frequency of the events, the fluctuations of risk premiums can be observed. In case of cat bonds covering USA earthquakes the risk premium is greater than those covering Japan earthquakes. Through the second model we aim to observe the determinants that influence risk premium. The explanatory variables taken into consideration are: the issuing amount, the probability of event occurrence, conditional expected loss, the probability of exhaustion, maturity, the rating and the trigger type of each bond. The results show that the probability of event occurrence and credit rating of the bond are significant determinants of risk premium, being considered by the investors when they decide to diversify their portfolio through financial instruments that are not affected by the volatility from financial markets. These results are mostly consistent with existing theoretical models but can also be observed certain differences which will be discussed. The moment when investors start to lose money is perceived more serious than the amount they will lose. As regards the rating, it offers information about the quality of the bond. Given the importance of this risk premium determinant we’ll also present the main factors considered by the rating agencies in the moment of setting a certain rating for a cat bond