Catastrophe Bond: As a Financial Innovation in Management of Catastrophe Risk

Catastrophe bond, as a typical alternative risk transfer financial product connecting insurance market and capital market, has emerged as a brand-new perspective for the transfer of catastrophe risk in the recent two decades. It possesses plenty of advantage to traditional reinsurance which serves similar function to catastrophe bond. In this paper, after introducing the background in which catastrophe bond was generated, the authors intends to show how catastrophe risk is efficiently transferred from insurance market to capital market through the use of special purpose vehicle. Then the pricing mechanism of catastrophe bond is brought forth and the three main steps and problems in them in the price-making process are investigated. In the end, through a substitution analysis between catastrophe bond and traditional reinsurance, the authors indicates that the optimal portfolio for an effective management catastrophe risk should be: reinsurance for losses that are relatively low, and catastrophe bond for losses that are higher.