Imf PHD 2000 CVC

SECURITIZATION OF INSURANCE RISK
CLAUS VORM CHRISTENSEN

DEPARTMENT OF THEORETICAL STATISTICS AND OPERATIONS
RESEARCH
UNIVERSITY OF AARHUS
DK-8000 AARHUS C, DENMARK
AUGUST 1, 2000
PHD THESIS
SUBMITTED TO THE FACULTY OF SCIENCE, UNIVERSITY OF
AARHUS
Prefa e
This thesis is the out ome of my PhD study and develops around
se uritization of insuran e risks. In parti ular it onsiders produ ts
related to atastrophe insuran e. The thesis is split into three major
se tions. The rst se tion gives a short summary of ea h of the ve
manus ripts in luded in the thesis, there is one in English and one
in Danish. The se ond se tion gives a longer review of the new main
results ontained in the thesis and dis usses how these results relates to
existing theories in the literature. The remainder of the thesis onsists
of the ve manus ripts. Cyni s would say that the se ond part exists
so that you will not have to read the manus ripts.
Some of the work in the thesis was developed while I was visiting the
nan ial and insuran e mathemati s group at the ETH, Zuri h 1998-
1999 and Laboratory of A tuarial Mathemati s, University of Copen-
hagen 2000. I am grateful to Paul Embre hts and Ragnar Norberg
respe tively for making these stays possible.
The work in this thesis has beneted from stimulating dis ussions,
suggestions and omments from a number of persons. Credits are due
to Susan Bla k (PCS), Amy Casey (CBoT), Bent Jesper Christensen,
Sam Cox, Freddy Delbaen, Paul Embre hts, Damir Filipovi , Asbjrn
Trolle Hansen, Jrgen Homann-Jrgensen, Dena Karras (CBoT), Ran-
di Mosegaard, Thomas Mller, Jrgen Aase Nielsen, Ragnar Norberg,
Jesper Lund Pedersen, Rolf Poulsen, Tina H. Rydberg, Uwe S hmo k,
Mogens Steensen, Mi hael K. Srensen, Jim Welsh (PCS), and of
ourse my supervisor Hanspeter S hmidli.
Contents
Summaries of Manus ripts in the Thesis (English) i
Summaries of Manus ripts in the Thesis (Danish) iv
1. Introdu tion 1
2. The dieren e between nan ial and a tuarial pri ing 1
2.1. Insuran e pri ing 1
2.2. Pri ing in nan e 3
2.3. The interse tion between insuran e and nan e 4
3. Se uritization, the CAT-future 7
3.1. Des ription of the CAT-future 8
3.2. The CAT-future pri ing problem 9
3.3. Pri ing based on a tually reported laims 10
4. Se uritization, the PCS-option 13
4.1. Des ription of the PCS-option 14
4.2. Why the PCS-option was an improvement 14
4.3. New pri ing models for the PCS-option 16
5. Implied loss distributions 21
5.1. The models 22
5.2. The obje tive fun tion 26
5.3. The parameter estimation 28
5.4. Other relevant referen es 31
6. The future of global reinsuran e 32
6.1. The model 33
6.2. How to handle unknown risk in a omplete market 34
6.3. The restri ted premium ase 35
6.4. The in omplete market ase 36
7. Con lusion 37
Referen es 40
Manus ripts 44
Manus ripts
Paper I: Pri ing atastrophe insuran e produ ts based on a tually

reported laims, 17 pages.
Paper II: The PCS option, an improvement of the CAT-future,

11 pages.
Paper III: A new model for pri ing atastrophe insuran e derivatives,
14 pages.
Paper IV: Implied loss distributions for atastrophe insuran e

derivatives, 19 pages.
Paper V: How to hedge unknown risk, 23 pages.

Summaries i
Summaries of Manus ripts in the Thesis (English)

This thesis onsists of the following ve papers:
Christensen, Claus Vorm and Hanspeter S hmidli, \Pri ing atas-
trophe insuran e produ ts based on a tually reported laims", (to
appear in Insuran e: Mathemati s and E onomi s).
Christensen, Claus Vorm, \The PCS-option, an improvement of
the CAT-future", (Manus ript, University of Aarhus).
Christensen, Claus Vorm, \A new model for pri ing atastrophe
insuran e derivatives", (Working Paper Series No. 28, Centre for
Analyti al Finan e).
Christensen, Claus Vorm, \Implied loss distributions for atastro-
phe insuran e derivatives", (Manus ript, University of Aarhus.)
Christensen, Claus Vorm, \How to hedge unknown risk", (Manu-
s ript, University of Aarhus.)
Below I give a short summary of the ontent of ea h paper.
Refereed Publi ations

Christensen, Claus Vorm and Hanspeter S hmidli (1998), "Pri ing
atastrophe insuran e produ ts based on a tually reported laims", (to
appear in Insuran e: Mathemati s and E onomi s).
Abstra t: This arti le deals with the problem of pri ing a nan ial
produ t relying on an index of reported laims from atastrophe insur-
an e. The problem of pri ing su h produ ts is that, at a xed time
in the trading period, we do not know the total laim amount from
the atastrophes o urred. Therefore we have to pri e these produ ts
solely from knowing the aggregate amount of the reported laims at
the xed time point. This arti le will propose a way to handle this
problem by introdu ing a model taking reporting lags into a ount.
The main idea of the arti le is to model the aggregate laim from a
single atastrophe as a ompound (mixed) Poisson model. We thereby
obtain the possibility to separate the individual laims and to model
the reporting times of the laims. This new model and an illustration
of how pri e al ulations an be done in the model is the main purpose
of the arti le.
ii Summaries
Working Papers
\The PCS-option, an improvement of the CAT-future", (Manus ript,
University of Aarhus).
In 1992, Chi ago Board of Trade (CBoT) introdu ed the CAT-future
as an alternative to atastrophe reinsuran e. But the produ t never
be ame very popular, so in 1995 it was repla ed by a new produ t the
PCS-option. In relation to my PhD proje t, I therefore started ol-
le ting information about the PCS-option. The basi information was
obtained by reading [14℄ and [55℄. But some was also re eived by mail-
ing with people from the PCS and the CBOT. After having re eived
this information it seemed natural to gather it in a paper. This is done
here, together with an explanation of why the CAT-future was repla ed
by the PCS-option, and why the PCS-option is an improvement. The
paper also explains how to hedge atastrophe risk with PCS-options
and it ompares the PCS-option with traditional reinsuran e.
\A new model for pri ing atastrophe insuran e derivatives", (Work-
ing Paper Series No. 28, Centre for Analyti al Finan e.)
Sin e the introdu tion of the insuran e derivatives in 1992, it has been
a problem how to pri e these produ ts. The two main problems have
been the following. First if we hoose a realisti model for the under-
lying loss pro ess the market will be in omplete and there will exist
many equivalent martingale measures. Hen e there will exist several
arbitrage free pri es of the produ t. Se ond we want a Pareto like tail
for the underlying loss index, but heavy tails often give omputational
problems. It is therefore natural to look for a model that solves both
these problems. In this paper we present a model whi h in some sense
takes are of both problems. The model is inspired by results from
Gerber and Shiu [43℄. In [43℄ it is shown that the Ess her transform
is a unique and transparent te hnique for valuing derivative se urities
if the logarithms of the underlying pro ess are governed by a ertain
sto hasti pro ess with stationary and independent in rements (a Levy
pro ess). In this paper we propose su h a model, and by way of exam-
ple we al ulate pri es for the PCS-option, but the approa h an also
be used for pri ing other se urities relying on a atastrophe loss index.
\Implied loss distributions for atastrophe insuran e derivatives",
(Manus ript, University of Aarhus).
In this paper we also pri e atastrophe insuran e derivatives, but here
we lead our analysis in another dire tion than in the previous papers.
We follow a pro edure familiar to the onventional option market whi h
also is suggested by Lane and Mov han in [46℄, namely rather than
Summaries iii
estimating volatilities and al ulate onsistent pri es using, say the

Bla k S holes model, take the traded pri es and extra t the volatilities
onsistent with those pri es, i.e. nd the implied volatility. We annot
use the same pro edure on the insuran e derivative market dire tly
sin e we are not able to hara terize the pri e by a single parameter.
But we an do something similar. We an hoose a model for the
implied loss distribution and then estimate the implied parameters from
the observed pri es.
This analysis an be used to evaluate heapness and dearness among
dierent pri es and dierent insuran e derivative produ ts. We simply
al ulate implied pri es from the implied loss distributions and om-
pare them to the observed pri es. There are two main problems in
this analysis. First, what kind of distribution should be hosen for
the implied losses and se ond, how should the involved parameters be
estimated? In this paper we analyse those two problems and end up
by re ommending a new implied loss distribution and a new obje tive
fun tion for estimating the parameters.
\How to hedge unknown risk", (Manus ript, University of Aarhus).
In this paper we are onsidering risk with more than one prior estimate
of the frequen y, e.g. environmental health risk of new and little known
epidemi s, or risk indu ed by s ienti un ertainty in predi ting the
frequen y and severity of atastrophi events. It is not possible to
hedge this kind of risk using only traditional insuran e pra ti e. A
new method is alled for.
This problem was rst mentioned by Chi hilnisky and Heal in [15℄
(a non mathemati al paper), where they argued that this unknown
risk should be managed by using traditional insuran e pra ti e and by
trading in the se urity market simultaneously. In this arti le we will
ontinue and extend the ideas from [15℄. The main purpose is to build
a mathemati al model that is able to handle this and related problems.
In the paper we extend the ideas from [15℄ by onsidering both om-
plete and in omplete markets. Furthermore we onsider the ase where
the premium harged by the insuran e ompany is restri ted. In this
ase the insuran e ompany has to hoose an allo ation of the restri ted
premium orresponding to the states of the world. We propose four dif-
ferent methods for solving this problem. These four methods are then
analysed and evaluated; advantages and disadvantages are illustrated
by examples.
iv Summaries
Summaries of Manus ripts in the Thesis (Danish)

Afhandlingen indeholder flgende fem artikler:
Christensen, Claus Vorm and Hanspeter S hmidli, \Prisfastst-
telse af katastrofeforsikrings produkter baseret pa aktuelle, rap-
porterede skader", (udkommer i Insuran e, Mathemati s and E o-
nomi s).
Christensen, Claus Vorm, \PCS-optionen, en forbedring af CAT-
futuren" (Manuskript, Aarhus Universitet).
Christensen, Claus Vorm, \En ny model til prisfaststtelse af
katastrofeforsikrings derivater", (Working Paper Serie No. 28,
Center for Analytisk Finansiering.)
Christensen, Claus Vorm, \Markedsudledte skadesfordelinger for
katastrofeforsikrings derivater", (Manuskript, Aarhus Universitet).
Christensen, Claus Vorm, \Hvordan man afdkker ukendt risiko",
(Manuskript, Aarhus Universitet).
Herunder flger et kort referat af indholdet i de fem artikler.
A epterede artikler
Christensen, Claus Vorm and Hanspeter S hmidli (1998), "Prisfast-
sttelse af katastrofeforsikrings produkter baseret p
a aktuelle rapporterede
skader", (udkommer i Insuran e, Mathemati s and E onomi s).
Resume: Denne artikel omhandler problemer ved prisfaststtelse
af et nansielt aktiv, som beror p a et index af rapporterede skader
fra katastrofeforsikringer. Problemet ved at prisfaststte s
adanne pro-
dukt er, at man p a et givet tidspunkt i handelsperioden ikke kender
det totale skadesbelb fra allerede indtrufne katastrofer. Man skal der-
for prisfaststte produktet udelukkende ud fra kendskabet til belbet
af de rapporterede skader til et givet tidspunkt. Denne artikel anviser
en m ade hvorpa man kan lse dette problem. Hovedideen i artiklen
er at modellere de samlede skader fra en katastrofe som en sammen-
sat (blandet) Poisson model. Vi opn ar derved muligheden for at se-
parere de individuelle skader og modellere rapporteringstidspunkterne
for skaderne. Denne nye model og en illustration af hvordan man kan
beregne priser i modellen er hovedbudskabet i artiklen.
Summaries v
Working Papers
\PCS-optionen, en forbedring af CAT-futuren", (Manuskript, Aarhus
Universitet).
I 1992 indfrte CBoT CAT-futuren som et alternativ til katastrofe gen-
forsikring. Men produktet blev aldrig rigtigt populrt, sa i 1995 blev
det erstattet af PCS-optionen. I relation til mit PhD studie, start-
ede jeg derfor med at indsamle information om PCS-optionen. Den
mest basale information stammer fra artiklerne [14℄ og [55℄. Derudover
blev en del information indhentet via personlig kontakt ved ansatte ved
PCS og CBoT. Efter at have indhentet denne information fandt jeg det
naturligt, at samle den i en artikel. Det er gjort i denne artikel, som
ogsa forklarer hvorfor CAT-futuren blev erstattet af PCS-optionen og
hvorfor PCS-optionen er en forbedring. Artiklen forklarer ogs a hvor-
dan man afdkker katastroferisiko og sammenligner PCS-optionen med
almindelig genforsikring.
\En ny model til prisfaststtelse af katastrofeforsikrings derivater",
(Working Paper Serie No. 28, Center for Analytisk Finansiering).
Siden nansielle katastrofe forsikringsprodukter blev indfrt i 1992, har
det vret et problem hvordan disse produkter skulle prisfaststtes.
Der har vret flgende to hovedproblemer. For det frste, hvis vi
vlger en realistisk model for den underliggende tabspro es, s a bliver
markedet ufuldstndigt og som flge heraf eksisterer der mange kvi-
valente martingalm al. Dette betyder at der eksisterer mange arbitrage
frie priser p
a produktet. Det andet problem er at vi gerne vil have
at fordelingen for det underliggende tabs index har en tung hale, men
tunge haler giver ofte beregningsmssige problemer. Det har derfor
vret naturligt at lede efter en model der lser begge disse problemer.
I denne artikel prsenterer vi en model, der i en vis henseende tager
hjde for begge disse probelmer. Modellen er inspireret af resultater
fra Gerber og Shiu [43℄. I [43℄ er det vist at Ess her transformen er en
entydig og umiddelbar teknik for vrdifaststtelse af aktiver, hvor log-
aritmen af den underliggende pro es er styret af en bestemt stokastisk
pro es med stationre og uafhngige tilvkster (en Levy pro es). I
denne artikel foresl
ar vi en s
adan model, og som eksempel beregner vi
prisen for PCS-optionen. Metoden kan ogs a benyttes til prisfastst-
telse af andre aktiver, der beror pa et katastrofetabs index.
\Markeds udledte skadesfordelinger for katastrofeforsikrings derivater",
(Manuskript, Aarhus Universitet).
I denne artikel forsger vi ogs
a at prisfaststte katastrofe forsikrings
derivater, men vi drejer nu vores analyse i en anden retning end i
vi Summaries
de tidligere artikler. Vi benytter en metode, som ogs a er kendt fra

det almindelige optionsmarked, og som ogs a er foresl
aet af Lane and
Mov han in [46℄. I stedet for at estimere volatiliteter og beregne kon-
sistente priser ved hjlp af for eksempel Bla k S holes, s a tages her
udgangspunkt i de handlede priser og derfra udledes den volatilitet,
der er konsistent med disse priser, dvs. den markedsudledte volatilitet.
Vi kan ikke bruge den samme pro edure direkte p a katastrofeforsikrings
derivater, idet det typisk ikke er muligt at karakterisere prisen for
disse ved hjlp af en enkelt parameter. Vi kan derimod gre no-
get tilsvarende. Vi kan vlge en model for de markedsudledte tabs-
fordelinger, og sa estimere de markedsudledte parametre hrende til
disse fordelinger ud fra de observerede priser.
Denne analyse kan s a bruges til at evaluere forskellige priser p a
forskellige katastrofeforsikrings derivater. Vi beregner simpelthen bare
de impli itte priser ud fra de markedsudledte skadesfordelinger, og sam-
menligner dem med de observerede priser. Der er to hovedproblemer i
denne analyse. For det frste, hvilken fordeling skal vi vlge for den
markedsudledte skadesfordeling og for det andet, hvordan skal de ind-
volverede parametre estimeres? I denne artikel analyserer vi disse to
problemer og foreslr en ny skadesfordeling samt en ny objektfunktion
til parameterestimation.
\Hvordan man afdkker ukendt risiko", (Manuskript, Aarhus Uni-

versitet).
I denne artikel betragter vi risiko med mere end et indledende es-
timat af risikoens frekvens, eksempelvis miljmssig sundhedsrisiko
ved nye og ukendte epidemier, eller risikoen ved den videnskabelige
usikkerhed forbundet med at forudsige frekvensen og styrken af en
given naturkatastrofe. Det er ikke muligt at afdkke denne risiko
udelukkende ved at benytte traditionel forsikringspraksis. Der er behov
for en ny metode.
Dette problem blev frste gang nvnt af Chi hilnisky og Heal i [15℄
(en ikke matematisk artikel), hvor de argumenterede for, at det skulle
vre muligt at styre denne form for risiko ved simultant at benytte
traditionel forsikringspraksis og handle p a det nansielle marked. I
denne artikel vil vi tage udgangspunkt i [15℄ og videreudvikle ideerne
derfra. Hovedform alet med artiklen er at konstruere en matematisk
model som er i stand til at lse dette og tilhrende problemer.
I artiklen udvider vi ideerne fra [15℄ ved at betragte b ade fuld-
stndige og de ufuldstndige nansielle markeder. Derudover be-
tragter vi ogs
a den situation, hvor forsikringsselskabet kun kan forlange
en begrnset prmie. I det tilflde er forsikringsselskabet ndt til at
Summaries vii
vlge en allokering af den begrnsede prmie hrende til de forskel-

lige mulige tilstande. Vi foresl
ar re forskellige mader at lse dette
problem pa. Disse re metoder bliver s
a analyseret og evalueret og ved
eksempler bliver fordele og ulemper skitseret.
Pri ing 1
1. Introdu tion
During the nineties a highly dis ussed theme among a ademi s has
been the interplay between insuran e and nan e. Some of the gen-
eral issues have been: the in reasing ollaboration between insuran e
ompanies and banks; the dis ussions about risk management method-
ologies for nan ial institutions, and the emergen e of nan e related
insuran e produ ts, e.g. atastrophe futures and options, PCS options,
index-linked poli ies,........
This thesis develops around the interplay between insuran e and -
nan e and espe ially around the pri ing of nan e related insuran e
produ ts (insuran e derivatives). The insuran e derivative was devel-
oped as a nan ial produ t whi h should work as an alternative or
repla ement of reinsuran e. This meant that ompanies that would
normally redu e their risk by reinsuran e, ould now onsider these
new nan ial produ ts as alternatives. One of the main dieren es be-
tween the traditional on ept of reinsuran e and these new produ ts,
is the way they are pri ed. Reinsuran e ontra ts are pri ed using
traditional a tuarial methods, whereas derivatives should be pri ed by
nan ial methods of no arbitrage. To give an impression of the dif-
feren es between these two methods of pri ing, we start this se ond
major se tion with a des ription of the two methods of pri ing and
their intera tion.
The rest of this se ond se tion of the thesis, gives a hronologi al
des ription of how the market for atastrophe insuran e produ ts has
developed, with a spe ial fo us on the pri ing approa h. Here rele-
vant literature is des ribed and it is explained how my work relates to,
ontributes to, and extends various elds.
2. The differen e between finan ial and a tuarial

pri ing
As mentioned above I found it appropriate to stress how nan ial
and a tuarial pri ing are related to one another. This is done by rst
des ribing the pri ing pro edures in insuran e, then the pri ing pro e-
dures in nan e and nally by making some remarks on the intera tion.
The following subse tions are losely related to the ni e paper [30℄, but
are also based on theory from [28℄, [32℄, [52℄ and [53℄.
2.1. Insuran e pri ing. Let the annual premium for a ertain risk
be , denote by Xi the losses in year i and assume that the Xi 's are
independent and identi ally distributed. The ompany has a ertain
2 Pri ing
initial apital u. Then the apital of the ompany after year i is

i
X
Ci = u + i Xj
j =1
It is well-known, see e.g. [53℄, that only if > EP [Xi ℄ there is a positive
probability that Ci 0 for all i 2 IIN, i.e. one should be prepared to
pay more than E [Xi ℄ (a safety loading is added). That agents are in
fa t willing to pay more than EP [Xi ℄ an be shown by looking at utility
theory. Consider an agent who is going to buy an insuran e to over
the losses Xi . Assume that the agent has initial apital k and utility
fun tion w, where w0 > 0 (more is better) and w00 < 0 (de reasing
marginal utility) and that VarP [Xi ℄ 6= 0. Then the agent is willing to
pay the premium ~ dened by the equation
w(k ~ ) = EP [w(k Xi )℄:
The denition of w implies that w is onvex and therefore Jensen's
inequality immediately leads to
~ > EP [Xi ℄:
An insuran e ontra t between the agent and the insurer is now alled
feasible whenever
~ > EP [Xi ℄:
One an now hoose among various well-known premium prin iples
for the valuation of the premium. We will now des ribe some of these
premium al ulation prin iples for the risk X .
The expe ted value prin iple
= EP [X ℄ + ÆEP [X ℄
The varian e prin iple
= EP [X ℄ + Æ VarP [X ℄
The standard deviation prin iple
= EP [X ℄ + Æ (VarP [X ℄)1=2
The loading fa tor Æ is often determined by setting suÆ iently prote -
tive solven y margins whi h may be derived from ruin estimates of the
underlying risk pro ess over a given (nite) period of time.
The exponential prin iple: Assume that the insuran e ompany
has initial apital h and utility fun tion v , where v 0 > 0 and
Pri ing 3
v 00 < 0. The premium for the insuran e ompany an be dened

by the equation
v (h) = EP [v (h + X )℄:
If the insuran e ompany has an exponential utility fun tion, i.e.
v (x) = 1 e Æx we, obtain by the above denition the exponential
prin iple
1
= log EP [eÆX ℄:
Æ
The per entage prin iple: The ompany wants to keep the proba-
bility that the risk ex eeds the premium in ome small. The om-
pany therefore hooses a parameter and denes the premium
by
= inf fy > 0 : P [X > y ℄ g:
The Ess her prin iple:
E [XeÆX ℄
= P ÆX :
EP [e ℄
for an appropriate Æ > 0. An e onomi foundation for the Ess her
prin iple, using risk ex hange and equilibrium pri ing has been
given by Buhlmann in [9℄.
2.2. Pri ing in nan e. When we hange from the pri ing in insur-
an e to the pri ing in nan e, the risk X typi ally be omes a ontingent
laim. Let us onsider some examples. Let (St )0tT denote the un-
derlying pri e pro ess of some traded asset. The risk of a European
all with strike K and maturity T is then
X = (ST K )+
Note that this ontra t is similar to an ex ess-of-loss reinsuran e treaty
with priority K . Another example is the Asian option with strike pri e
K , whi h spe ies the payo
Z
1 T
X =( S du K )+ :
T 0 u
This ontra t is similar to the stop-loss treaty in reinsuran e.
In the nan e ontext, the argument against using EP [X ℄ as the
premium is based on the notion of no-arbitrage. The orre t pri e
at time t of a ontingent laim X , in a no-arbitrage framework with
risk-free interest rate r, is
vt = EQ [e r(T t) X jFt ℄
4 Pri ing
and the premium to be harged at time t = 0

v0 = EQ [e rT ) X ℄;
see [28℄ for further details. We al ulate the fair premium with respe t
to another probability measure Q. This risk neutral probability mea-
sure Q hanges the original measure P in order to give more weight to
unfavorable events in a risk averse environment. In nan ial e onomi s
this leads to the on ept of \the market pri e of risk" and in insuran e
mathemati s it should explain the safety loading.
In omplete markets Q is the unique P -equivalent probability mea-
sure whi h turns e rt St into a martingale. In in omplete models Q is
not unique, and without further information on investor spe i pref-
eren es only bounds on pri es an be given.
Examples of omplete models:
Geometri Brownian motions (Bla k-S holes),
multi-dimensional geometri Brownian motions,
(Nt t)t0 with Nt a homogeneous Poisson pro ess with intensity
, and R
square integrable point pro ess martingales (Nt 0t sds)t0, for
deterministi .
Examples of in omplete models:
Sto hasti volatility models with unhedgable volatility risk, and
pro esses with jumps of random size (e.g. ompound Poisson pro-
esses and general jump diusions).
If one hooses a martingale measure in the in omplete market one
will at the same time hoose the weights for the dierent risks and
then impli itly the markets utility fun tion, i.e. one ould argue that
it would be natural to work out the in omplete market pri e in a utility
maximization framework. If one does so, a unique measure emerges in
a very natural way, see [32℄ and referen es therein. Other important
referen es for readers interested in in omplete markets are [37℄ and [38℄.
2.3. The interse tion between insuran e and nan e. The las-
si al risk pro ess, being dened as a ompound Poisson pro ess, is
traditionally used as a model for insuran e business. And as we have
seen in Subse tion 2.1 the premium to be asked per unit of time is
dened as the expe tation plus some loading fa tor. It ould then be
interesting to investigate whether the nan ial approa h from the pre-
vious subse tion ould be used to al ulate premiums for risk pro esses,
and how these premiums are related to the premiums obtained in Sub-
se tion 2.1. This is exa tly the aim of the paper [27℄ by Delbaen and
Haezendon k. Let us now outline the method introdu ed in this paper.
Pri ing 5
For a given nite time horizon [0; T ℄ we onsider a ompany holding

the risk pro ess L given by a ompound Poisson pro ess
Nt
X
Lt = Yi
i=1
where the Yi 's are independent and identi ally distributed positive
laims with ommon distribution fun tion F . Nt is a homogeneous
Poisson pro ess with intensity > 0 and independent of (Yi )i1 .
Let (S~t )0tT be the dis ounted pri e pro ess for the laim LT . Del-
baen and Haezendon k then at this point on lude, that the liquidity of
the market makes it reasonable to assume that the market is arbitrage
free, i.e. there exists a risk neutral probability measure under whi h
the dis ounted pri e pro ess (S~t )0tT is an Ft -martingale. Thus:
S~t = EQ [LT jFt ℄; 0 t T:
Suppose that at ea h time t, the ompany an sell the remaining risk
of the period ℄t; T ℄ for a given (predi table) premium t . Sin e t is a
premium that admits no arbitrage, it is determined as
t = EQ [LT Lt jFt ℄; 0 t T;
= EQ [LT jFt ℄ Lt ; 0 t T:
Hen e, the underlying pri e pro ess (S~t )0tT an be de omposed into
S~t = t + Lt 0 t T:
or in other words, the ompany's liabilities S~t at time t onsist of the
laims up to time t and the premium for the remaining risk LT Lt .
If one further more imposes that
t = (T t) 0 t T;
where is a premium density, i.e. the premium is linear in time, then
we obtain that under Q the risk pro ess Lt remains a ompound Pois-
son pro ess. We therefore onsider only those equivalent martingale
measures Q that preserve the ompound Poisson property of Lt within
this non-arbitrage insuran e ontext. A viable premium density then
takes the form
Q = EQ[L1 ℄ = EQ [N1 ℄EQ [Y1 ℄;
resulting in hange of both laim-size and laim-intensity of the under-
lying pro ess. It is then shown that the Q-measures giving rise to su h
6 Pri ing
viable premium prin iples have the following properties (formulated in

terms of distribution fun tions):
x Z
1
F () (x) =
Q e(y) dF (y ); x 0
EP [exp( (Y1 ))℄ 0
where : IR+ ! IR is in reasing so that
EP [exp( (Y1 ))℄ < 1 and EP [Y1 exp( (Y1 ))℄ < 1
The resulting premium density then satises for (y ) 0,
P = EP [N1 ℄EP [Y1 ℄ < Q() < 1
hen e taking safety loading into a ount. Spe ial hoi es of now lead
to spe ial premium prin iples, all onsistent within the no-arbitrage
set-up. Examples are:
(x) = > 0, then
Q() = e EP [N1 ℄EP [Y1 ℄ = e EP [Y1 ℄ (the expe ted value prin-
iple);
(x) = log(a + bx), 0 < b < (EP [Y1℄) 1 and a = 1
bEP [Y1 ℄ > 0,
then
Q() = (EP [Y1 ℄ + bVarP [Y1 ℄) (the varian e prin iple);
(x) = x log EP [eY ℄, > 0, then
1
Q() = EEP P[Y[exp(

1 exp(Y )℄ (the Ess her prin iple).
1
1
Y )℄
So, in a suÆ iently liquid insuran e market, lassi al insuran e pre-

mium prin iples an be reinterpreted in a standard no-arbitrage pri ing
set-up. The main results from [27℄ are generalized in [47℄ to be valid
for mixed Poisson and doubly sto hasti Poisson pro esses as well.
Consider now a ontingent laim based on a loss pro ess. One ould
then derive arbitrage-free pri es of su h ontingent laims on the basis
of the risk-neutral probability measure derived above. This is done
in [4℄ where pri es are al ulated for dierent risk-neutral measures.
The pri es are al ulated by solving integro-dierential equations for
the ontingent laims numeri ally. But the risk neutral measure is not
unique, so there still exist several possibilities to pri e these ontingent
laims ex luding arbitrage opportunities. A natural way to hoose
a spe i measure ould then be, as argued above, to work out the
in omplete market pri e in a utility maximization framework. And as
stated above a unique measure emerges in a very natural way. We will
dis uss this further in the next se tion.
Se uritization, the CAT-future 7
3. Se uritization, the CAT-future

Let us start this se tion by listing the 10 most ostly insuran e losses
in the period 1970-1999. The data an be found in sigma [58℄ (the
insured losses are in USD millions at 1999 pri es).
Date Event loss

24.08.1992 Hurri ane \Andrew", USA 19086
17.01.1994 Northridge earthquake, Calif. 14122
27.09.1991 Typhoon \Mireille", Japan 6906
25.01.1990 Winter storm \Daria", Europe 5882
15.09.1989 Hurri ane \Hugo", Puerto Ri o 5664
25.12.1999 Winter storm \Lothar", Europe 4500
15.10.1987 Autumn storm, Europe 4415
26.02.1990 Winter storm \Vivian", Europe 4088
20.08.1998 Hurri ane \George", USA 3622
22.09.1999 Typhoon \Bart" hits south Japan 2980
Table 3.1. The 10 most ostly insuran e losses (1970-1999).
From table 3.1 it is seen that all 10 events have happened during
the se ond half of the period. One therefore gets the impression that
the frequen y and severity of large losses has in reased, whi h is also
onrmed in [58℄. This in rease is due to higher population densities,
more insured values in endangered areas and higher on entration of
values in industrialized ountries.
The insuran e industry already got the impression of this in rease
in the early nineties after hurri ane Andrew and the Northridge earth-
quake. And they soon realized that the reinsuran e industry might la k
the apital to over the huge atastrophes of the future. To solve this
problem se uritization of atastrophe risk was invented. The idea of
se uritization was to transfer some of the risk from the insuran e mar-
ket to the nan ial market, where the risk-bearing apa ity is mu h
larger. This transfer should then be done by use of nan ial instru-
ments su h as options and futures on indi es of atastrophe losses or
atastrophe bonds. Catastrophe bonds are bonds where the payment
of the oupon and/or the return of the prin ipal of the bond is linked
to the non-o urren e of a spe ied atastrophi event. In the rest
of the thesis we will denote these nan ial instruments as atastrophe
insuran e derivatives.
We now give a short des ription of one of the rst produ ts of this
kind, namely the CAT-future introdu ed by CBoT in 1992.
8 Se uritization, the CAT-future
3.1. Des ription of the CAT-future. CAT-futures are traded at

CBoT on a quarterly y le, with ontra t months Mar h, June, Sep-
tember and De ember. A ontra t for a alendar quarter ( alled the
event quarter) is based on losses o urring in the listed quarter and
being reported to the parti ipating ompanies by the end of the follow-
ing quarter. A ontra t also spe ies an area and the type of laim to
be taken into a ount. The additional three months following the re-
porting period is attributable to data pro essing lags. The six months
period following the start of the event quarter is alled reporting pe-
riod. The three reporting months following the event quarter are to
allow for settlement lags that are usual in insuran e. The ontra ts
expire on the fth day of the fourth month following the end of the
reporting period. Let T1 < T2 be the end of the event quarter and the
end of the reporting period, respe tively.
The settlement value of the ontra t is determined by a loss index;
the ISO-index. Let us now onsider the index. Ea h quarter approxi-
mately 100 Ameri an insuran e ompanies report property loss data to
the ISO (Insuran e Servi e OÆ e, a well-known statisti al agent). ISO
then sele ts a pool of at least ten of these ompanies on the basis of
size, diversity of business, and quality of reported data. The ISO-index
is al ulated as the loss-ratio of this pool
reported in urred losses
ISO-index = :
earned premiums
The list of ompanies in luded in the pool is announ ed by the CBoT
prior to the beginning of the trading period for that ontra t. The
CBoT also announ es the premium volume for ompanies parti ipating
in the pool prior to the start of the trading period. Thus the premium in
the pool is a known onstant throughout the trading period, and pri e
hanges are attributable solely to hanges in the market's expe tation
of loss liabilities.
The settlement value for the CAT-futures is
FT = 25 000 min(IT ; 2)
2 2
where IT is the ISO-index at the end of the reporting period, i.e. the
2
ratio between the losses in urred during the event quarter and reported
up till three months later and the premium volume for the ompanies
parti ipating in the pool.
Example 3.1. The June ontra t overs losses from events o urring
in April, May and June and are reported to the parti ipating ompanies
by the end of September. The June ontra t expires on January 5th
the following year. The ontra t is illustrated by Figure 3.1.
Apr May June July Aug Sep Oct Nov Dec Jan
INTERIM REPORT FINAL SETTLEMENT

EVENT QUARTER
REPORTING PERIOD
Figure 3.1. June CAT-Future ontra t

3.2. The CAT-future pri ing problem. Sin e the introdu tion of
the CAT-future in 1992, it has been a highly dis ussed theme among
a ademi s how these atastrophe insuran e derivatives should be pri ed.
It has not been possible to nd a unique model like the Bla k-S holes
model sin e the underlying index annot be des ribed by a distribution
as simple as the log-normal, and furthermore, the underlying is not a
traded asset.
One of the rst attempts to pri e these derivatives was done by
Cummins and Geman in [24℄. This paper develops an Asian option
model for the pri ing of the CAT-future. They argue that the Asian
approa h is appropriate sin e most insuran e ontra ts, in luding the
CAT-future, have pay-os dened in terms of laims a umulations
rather than the end-of-period values of the underlying state variables.
For the underlying index [24℄ use the model
Z T
LT = S (s)ds
0
where
dS (t) = S (t )dt + S (t )dW (t) + kdN (t):
In order to pri e the CAT-future they then assume that there exist two
other se urities on the market from whi h one an derive the behavior
of the pro esses W (t) and N (t) under the Q-measure. Under these
assumptions they are able to pri e the CAT-future by use of te hniques
arising from pri ing Asian options.
The model, however, seems to be far from reality. At times where
a atastrophe o urs or shortly thereafter, one would expe t a strong
in rease of the loss index. It is therefore preferable to use a marked
point pro ess as it is popular in a tuarial mathemati s. But if we
look after su h a model we will also have to look for another pri ing
approa h, sin e we are then no longer able to pri e by no arbitrage.
A model of this type was suggested by Aase in [1℄. Here a ompound
Poisson model is used. This an be seen as atastrophes o urring
at ertain times and laims being reported immediately. In su h a

model there would be no need for the prolonged reporting period. In
[1℄ a losed form pri ing model is derived in the framework of general
e onomi equilibrium theory under un ertainty.
An improvement of this model is the model suggested by Embre hts
and Meister in [32℄. In this ase a doubly sto hasti Poisson model
is introdu ed. Here, a high intensity level will o ur shortly after a
atastrophe, where more laims are expe ted to be reported. For the
pri ing of the derivative, a utility and risk-minimization approa h is
used, and in the ase of the exponential utility fun tion, we obtain the
following pri ing formula. Let Ft be the pri e of the future, Lt the value
of the losses o urred in the event quarter and reported till time t, Ft
the information at time t, premiums earned and let = 25 000=.
Then the pri e at time t, is (see [32, p.19℄)
E [exp(L1 ) (LT ^ 2) j Ft ℄
(3.1) Ft = P 2
:
EP [exp(L1 ) j Ft ℄
In parti ular, EP [exp(L1 )℄ has to exist. The market will determine
the risk aversion oeÆ ient . This pri ing formula is also the one we
use in Christensen and S hmidli [17℄. In the next se tion we outline
the main results from [17℄.
3.3. Pri ing based on a tually reported laims. One of the prob-
lems with pri ing these nan ial produ ts relying on indi es of reported
laims from atastrophe insuran e is that, at a xed time in the trading
period, the total laim amount from the atastrophes o urred is not
known. One therefore has to pri e these produ ts solely from knowing
the aggregate amount of the reported laims at the xed time point.
The idea of the manus ript [17℄ was to derive a pri ing model that
was only based on the a tually reported laims and thereby extend the
existing pri ing models for produ ts of this kind.
The main idea of [17℄ is to model the aggregate laim from a sin-
gle atastrophe as a ompound (mixed) Poisson model. We thereby
obtain the possibility to separate the individual laims and to model
the reporting times of the laims. In [17℄ it is shown how pri es an
be al ulated within this new model. For pri ing the atastrophe in-
suran e futures and options we use the exponential utility approa h of
[32℄. This approa h will only work for aggregate laims with an expo-
nentially de reasing tail. But data give eviden e that the distribution
tail of the aggregate laims is heavy tailed. In our model a heavy-tail
an be obtained by a heavy-tailed distribution for the number of indi-
vidual laims of a single atastrophe. For pri ing we approximate the
laim number distribution by a negative binomial distribution; more

pre isely, by a mixed Poisson distribution with a ( ; )-mixing distri-
bution. Choosing and small a heavy-tail behaviour an be approx-
imated. The reader should note that the value of the se urity is based
on a apped index and therefore has an upper bound. This justies
the light-tail approximation.
3.3.1. The model. The model looks as follows. Catastrophes o ur at
times 1 2 3 : : : The i-th atastrophe produ es Mi laims with
sizes Yij . The j -th laim is then reported with lag Dij (Dij FD ),
i.e. at time i + Dij . Furthermore let Mi (t) be the number of laims
from atastrophe i reported until time t. In our model the laims Yij
from the i-th atastrophe are randomly ordered. This simplies the
modeling of the reporting lags Dij . Let (Di:j : 1 j Mi ) be the
order statisti s of the (Dij )1j Mi , and Yi:j be the laim orresponding
to Di:j . Then the laims o urred before T1 and reported till t T2
amount to
Nt^T1 Mi (t)
X X
Lt = Yi:j :
i=1 j =1
In parti ular, the nal aggregate amount, LT , an be represented as
2
Nt^T1 Mi (T2 ) NT1 i (T2 )

MX
X X X
LT = Lt +
2
Y i :j + Yi:j ;
i=1 j =Mi (t)+1 i=Nt^T1 +1 j =1
i.e. the nal aggregate amount LT an at time t be represented as a

2
sum of the laims that has already o urred and already been reported,
plus a sum of the laims that already o urred and will be reported be-
fore the end of the reporting period, plus a sum of laims that will o ur
before the end of the loss period and be reported before the end of the
reporting period. Based on the assumption that Mi is mixed Poisson
distributed we an show that Mi (t) also is mixed Poisson distributed
but with a dierent parameter dependent on the old parameter and
the distribution of the reporting lags, see [17℄ for further details.
Under, some additional assumptions, see [17℄, we then show that
LT Lt is a ompound Poisson sum, and we nd the distribution of
2
the parameter. This parameter depends on the (non-observable) mean
laim number of the i-th atastrophe (i ). We therefore work with
two models. First we work with a simple model assuming that i is
deterministi , i.e. all atastrophes have the same mean laim number.
Next we work with a model where the i is sto hasti , i.e. we allow
the parameter to depend on the information from the laims having

o urred in the past.
We now know the distribution of the underlying loss pro ess, and
in order to pri e the CAT-future we follow the approa h of Embre hts
and Meister [32℄, or more pre isely the pri ing formula (3.1). The term
exp(L1)=EP [exp(L1 )℄ from (3.1) is stri tly positive and integrates
to one. Thus it is the Radon-Nikodym derivative dQ=dP of an equiv-
alent measure. In the spe i model we will onsider, the pro ess (Lt )
follows the same model (but to be onsidered with dierent param-
eters) under the measure Q as under the measure P . For the exa t
behavior of Lt under Q, see [17℄. We will use this fa t to al ulate the
pri e.
3.3.2. The pri ing of the CAT-future. Denoting by F~L (; t) the distri-
bution fun tion of LT Lt under Q onditioned on Ft . We an then
2
express the pri e at time t of the CAT-future as
EQ [LT ^ 2jFt ℄
2
= (Lt + EQ [(LT 2
Lt ) ((LT 2
Lt ) (2 Lt ))+ j Ft ℄)
Z 1
(3.2) = Lt + EQ[(LT 2
Lt ) j Ft ℄ (1 F~L (x; t)) dx :
2 Lt
The problem with the above expression, however, is that we have to
nd the n-fold onvolutions of FD [T2 ~℄ (~ is uniformly distributed on
(t; T1 ), in order to al ulate the last term. To nd an expli it expression
seems to be hard.
Histori al data show that so far, the ap 2 in the denition of the
CAT-future has not been rea hed. The largest loss ratio was hurri-
ane Andrew with L1 = 1:79. Under the measure P we have that
fLT > 2g is a rare event. Sin e we are dealing with atastrophe
2
insuran e, the market risk aversion oeÆ ient annot be large. Oth-
erwise atastrophe insuran e would not be possible. We therefore as-
sume that fLT > 2g is also a rare event with respe t to the mea-
2
sure Q, see also [32℄. The light tail approximation to our model then
assures that the tail of F~L (; t) is exponentially de reasing. That is
R 1 ~
2 Lt (1 FL (x; t)) dx will be small as long as Q(LT > 2) is small.
2
The latter of ourse depending on the risk aversion oeÆ ient , be-
ing small in order to be able to negle t the last term. As in [32℄ we
therefore propose the approximation (Lt + EQ [(LT Lt ) j Ft ℄) to the
2
pri e of the CAT-future. For the exa t al ulation of this expression,
see [17℄. The nal result is also stated here in Theorem 3.2.
Se uritization, the PCS-option 13
In the extended model we assume that the i 's are sto hasti . This
an be seen as a measure of the severity of the atastrophe. For sim-
pli ity of the model, we assume that i an be observed via reported
laims only. Of ourse, in reality other information as TV-pi tures or
reports from the ae ted area will be available. Then for laims o ur-
ring before t we have some information on the intensity parameter i .
We therefore have to work with the posterior distribution of i given
Ft. It would be desirable if the prior and the posterior distribution
would belong to the same lass, see the dis ussion in [21, Ch.10℄. We
therefore hoose i to be distributed. Let i ( ; ). Under these
assumptions we again al ulate an approximation for the pri e of the
CAT-future, see [17℄ for an exa t al ulation. The nal result is stated
here in Theorem 3.6.
The above results are both approximations, so it is relevant to ask
how good these approximations are. This question is also onsidered
in [17℄. From equation 3.2 we know that the approximation error is
given by the following expression:
Z 1
(3.3) (1 F~L (x; t)) dx
2 Lt
where F~L (; t) denotes the distribution fun tion of LT Lt under Q
onditioned on Ft . The reason for omitting this term was that it is hard
2
to al ulate F~L (; t). In [17℄ we nd an approximation to the expression

above by using some of the approximations to LT Lt known from
2
a tuarial mathemati s, namely the translated gamma approximation
and the Edgeworth approximation. We use these two approximations
as examples whi h both are shown to be useful but other approxima-
tions may also possible.
The results in [17℄ are derived spe ially for the CAT-futures, even
though an improved nan ial atastrophe insuran e produ t, the PCS-
option, was introdu ed in 1995. In the next se tion we will onsider the
PCS-option and dis uss why the CAT-future was repla ed. The results
from [17℄ annot dire tly be used for pri ing PCS-options sin e they
have a dierent stru ture. However, be ause of a strong orrelation
between laims reported and the PCS-index, some of the ideas may be
used. We now turn to the PCS-option.
4. Se uritization, the PCS-option

In 1995 CBoT introdu ed the PCS-option as a repla ement of the
CAT-future. Let us brie y des ribe the PCS-option before we explain
why modi ations of the CAT-future was needed.
14 Se uritization, the PCS-option
4.1. Des ription of the PCS-option. In this se tion the denitions

of the keywords that spe ify the PCS-options are given. For a more
detailed des ription of the PCS-option see [14℄ or [16℄.
Property Claim Servi es (PCS), a division of Ameri an Insuran e
Servi es Group, is the re ognized industry authority for atastrophe
property damage estimates. PCS is a not-for-prot organization serv-
ing the insuran e industry.
The PCS-options are traded by Chi ago Board of Trade and are
regional ontra ts whose value is tied to the so- alled PCS Index. The
PCS index tra ks PCS estimates for insured industry losses resulting
from atastrophi events (as identied by PCS) in the area and loss
period overed. The options are traded as apped ontra ts, i.e. the ap
limits the amount of losses that an be in luded under ea h ontra t.
The value of a PCS all option at expiration day T , with exer ise pri e
A and ap value K is given by
C (T; LT ) = min(max(LT A; 0); K A)
where LT is the value of the PCS index at time T .
PCS-options an be traded as European alls, puts or spreads. Most
of the trading a tivity o urs in all-spreads, sin e they essentially work
like aggregate ex ess-of-loss reinsuran e agreements, see [16℄ for further
explanations.
The option in ludes both a loss period and a development period.
The loss period is the time during whi h a atastrophi event must
o ur in order for resulting losses to be in luded in a parti ular in-
dex. During the loss period, PCS provides loss estimates as atas-
trophes o ur. The development period is the time after the loss
period during whi h PCS ontinues to estimate and reestimate losses
from atastrophes o urred during the loss period. The reestimations
may result (and have resulted histori ally) in adjustments upwards and
downwards. PCS-option users an hoose either a six-month or twelve-
month development period. The settlement value for ea h index repre-
sents the sum of then- urrent PCS insured loss estimates provided and
revised over the loss and development periods.
4.2. Why the PCS-option was an improvement. The main prob-
lem of the CAT-future was aused by the onstru tion of the underlying
index, the ISO index. Let It be the value of the ISO index at time t.
One of the problems was that It was only published on e before the set-
tlement date. This took pla e just after the end of the reporting period
(the Interim report, see Figure 3.1). This meant that the ompanies
parti ipating in the pool had a possibility of knowing at least part of
the data used to form the index before the settlement date, while it
was ertainly more diÆ ult for other insurers. This reated an informa-
tion asymmetry whi h was a potential fa tor preventing people from
entering the market of CAT-futures. This problem was solved for the
PCS-option, be ause PCS reports the PCS loss indi es on ea h CBoT
trading day (the index is only hanged if there are new atastrophes
or if the index is adjusted) and neither Ameri an Insuran e Servi es
Group nor any person employed by Ameri an Insuran e Servi es Group
will dis lose any estimate of total insured losses following a atastro-
phe to any person prior to its oÆ ial publi ation. This means that all
investors re eive the same information at the same time. Thereby the
problem of asymmetri information is eliminated.
Another problem was the Moral Hazard problem. A ompany from
the pool ould manipulate data by delaying the report of a big loss so
that it rst would be in luded in the next reporting period and thereby
never ae t the index. The ompany's intension for doing so, ould be
that the ompany had agreed to a short position of a future ontra t1 .
That this possibility existed, ould also have prevented people from
entering the market of CAT-futures. This problem was also solved by
PCS ondu ting surveys of the market, when they estimate the loss
indi es. These surveys are ondential and they are not used dire tly
in the estimation of the indi es. So it is extremely diÆ ult for insuran e
ompanies to ae t the indi es, and thereby the Moral Hazard Problem
was eliminated.
A more serious problem ould o ur due to the reporting period being
too short. If a late quarter atastrophe o urs and laims are slow in
developing, then the nal laims ratio for the purpose of de iding the
future payo ould be low relative to the a tual nal laims ratio. This
problem o urred in the Mar h 1994 ontra t period, the period of the
Northridge earthquake. The settlement ratio was low and the ontra t
pay-o did not truly re e t the a tual laim loss. The onstru tion
of the PCS-option also solves this problem. The PCS index does not
dire tly depend on a number of reported laims and the time from the
end of the event period to the time the index is settled is also longer
for the PCS-option than it was for the CAT-future.
These problems being solved, was probably the main reason for the
PCS-options higher trading a tivity ompared to the CAT-future. But
the fa t that the new produ t was more logi ally onstru ted than
the old one, ould also have had an ee t. Hereby we mean that a
1 When a ompany, at time t and at a pri e Ft , enters a short position of a future

ontra t, it means that the ompany should pay (FT Ft ) to the other part of the
ontra t at time T. The ompany will then like FT to be as small as possible.
onstru tion using options instead of futures and \options on futures",

seems more logi al when all the trading a tivities are in options.
In fa t, the CBoT market has never progressed to a well laun hed
market. However, the market is still developing, and ompetitors su h
as The Bermuda Commodities Ex hange and The Catastrophe Risk
Ex hange are beginning to have some trading su ess, see [46℄. J.A.
Tilley [60℄ is mentioning the following four reasons why this market is
emerging so slowly. First, sin e 1994 there has been a generally favor-
able atastrophe loss experien e and as a result of this the reinsuran e
pri es have de reased. This be omes a problem be ause many edents
of risk, both primary writers and reinsurers, have onsidered se uriti-
zation as an alternative to reinsuran e rather than omplementary to
reinsuran e. Se ond, insurers are unwilling to be pioneers due to the
high development ost. Third, the fa t that the produ ts are un orre-
lated to other nan ial produ ts is not a good enough selling story for
investors. Investors want to understand the nature of the risk, and this
takes time. And nally, there still remains unanswered questions about
what form and stru ture of insuran e linked se urities and derivatives
will be viewed most favorable by investors.
4.3. New pri ing models for the PCS-option. Many of the mod-
els derived for the CAT-future an, with some adjustments, be used to
pri e the PCS-option. In addition, models have been derived, e.g. the
paper by Geman and Yor [39℄. In [39℄ they assume that the dynami s
of the laim index (Lt ) under Q is driven by the following sto hasti
dierential equation:
dLt = Wt dt + dNt
where Wt is a geometri Brownian motion, Nt is a Poisson pro ess and
is a positive onstant representing the magnitude of the jumps. In
the development period the last term is ex luded. Subsequently, they
then obtain quasi- ompleteness of the insuran e derivative market by
applying the Delbaen and Hazendonk [27℄ methodology to the lass of
layers of reinsuran e repli ating the all-spreads. The pri ing of the
all-spreads is then done by using sto hasti time hange, see [39℄ for
further details.
The model an, as the model by Cummins and Geman [24℄, be rit-
i ized for being unrealisti , be ause it is too light-tailed. As dis ussed
earlier a ompound Poisson model will be more realisti , but using the
approa h from the previous se tion we will still not be able to han-
dle heavy-tailed distributions for the jumps. An interesting question
is therefore the following. Does there exist a model for the loss index
whi h has a heavy-tail and still allows for a unique pri ing formula?
To present su h a model was the aim of the manus ript \A new model
for pri ing atastrophe insuran e derivatives" Christensen [18℄ and is
to our knowledge the rst paper with this agenda. We now give a short
presentation of this manus ript.
4.3.1. The model. The model we present below is inspired by Gerber
and Shiu [43℄. In [43℄ they show how one an obtain a risk neutral
Ess her measure in a unique and transparent way if the logarithms of
the value of the underlying se urity is a Levy pro ess. The idea is now
to hoose su h a model.
Let Lt be the underlying loss index for a atastrophe insuran e deriv-
ative, [0; T1 ℄ be the loss period and [T1 ; T2 ℄ be the development period.
We then assume that Lt for all t 2 [0; T2 ℄ is des ribed by
Lt = L0 exp(Xt )
where Xt is a Levy pro ess, and L0 2 IR+ . We model Xt dierently
in the loss period and the development period, for a similar model see
[55℄. The question is then how to model Xt for the loss period and for
the development period.
For t 2 [0; T1 ℄ we will model Xt by a ompound Poisson pro ess
Nt
X
Xt = Yi 8t 2 [0; T1℄
i=1
where Nt is a Poisson pro ess with a xed parameter 1 , and Yi is
exponentially distributed with parameter . We hereby obtain one of
the desired properties namely as mentioned above the heavy-tail for
Lt , e.g. when Xt Exp() then Lt L0 is Pa(; L0 ) distributed. But
as mentioned above this model is not hosen be ause it is the most
obvious one but be ause it has a heavy-tail, allows for u tuation and
gives a the possibility to express the pri e in losed-form. Therefore,
the model has some disadvantages ompared to a more natural model,
rstly the fa t that late atastrophes be ome more severe than earlier
ones and se ondly L0 = L0 > 0. For this reason this model should only
be used as a rst \ rude" approximation to the real world. We have
tried to work out these problems, but this seems to be hard.
We have to hoose a model for Xt for the development period. We
know that the adjustments are done both upwards and downwards we
will therefore again des ribe Xt as a ompound Poisson pro ess for
t 2 [T1 ; T2 ℄
N~t T1
X
Xt = XT + 1
Y~i
i=1
where N~t is a Poisson pro ess with a xed parameter 2 and Y~i is
normally distributed (N(; )), where the most natural hoi e of
is = 0 (unbiased previous estimates). In order to use the results
from Gerber and Shiu [43℄ we need to assume that the pro ess Xt for
t 2 [0; T1 ℄ is independent of the pro ess Xt XT for t 2 [T1 ; T2 ℄. In
1
the real world one will expe t some dependen e but the assumption is
invariable in order to use the results form [43℄.
The value of the option at time t is then
C (t; Lt ) = exp( r(T2 t))E [C (T2 ; LT )jFt ℄
2
where r is the risk free interest rate and E is the mean value a ording
to a risk neutral measure. Before we an pro eed further in the al u-
lation of the option pri e we will have to hoose a risk neutral measure.
This is done in the next se tions.
4.3.2. The pri ing of the PCS-option. This se tion des ribes how to
ompute a risk neutral measure using the Ess her Transform. The
theory was introdu ed by Gerber and Shiu [43℄. However we need to
make some adjustments in order to use their results in our ontext.
Let Lt be the value of the PCS index at time t
(4.1) Lt = L0 exp(Xt ); 8t 0;
where Xt is a Levy pro ess. Let M (z; t) be the moment generating
fun tion dened by:
Z 1
(4.2) M (z; t) := E [exp(zXt )℄ = exp(zx)F (dx; t)
1
provided the integral is nite, where F denotes the distribution fun tion
for Xt . Be ause of the independent stationary in rements we then have,
(see [34℄, se tion IX.5) , that
(4.3) M (z; t) = (M (z; 1))t
For any h 2 IR the Ess her-Transformation F (dx; t; h) is dened as:
exp(hx)F (dx; t)
(4.4) F (dx; t; h) = :
M (h; t)
From this transformed density we dene the Ess her-transformed mo-
ment generating fun tion as:
Z 1
M (z + h; t)
(4.5) M (z; t; h) = exp(zx)F (dx; t; h) = :
1 M (h; t)
Then it follows from (4.3) and (4.5) that
(4.6) M (z; t; h) = (M (z; 1; h))t
The idea of Gerber and Shiu [43℄ is to hoose h = h su h that

the dis ounted underlying pro ess here fe rt Lt g be omes a martin-
gale under the Ess her transformed measure. But absen e of arbitrage
arguments do not apply be ause the underlying pro ess Lt is a loss
index and not a pri e pro ess, i.e. it gives no meaning to derive the
risk neutral measure under the onditions that fe rt Lt g should be a
martingale. So we have to onsider another pro ess. Let Pt be the
deterministi premium paid till time t to re eive the value Lt at time
t and assume that the index fLt =Pt g is a traded asset. We then use
the idea of Gerber and Shiu by hoosing h = h su h that the pro ess
fe rtLt =Ptg is a martingale under the Ess her transformed measure.
The question now is how to model Pt . We have to onsider the
loss period and the development period separately. Therefore we rst
onsider the loss period. We would like the premium to be arbitrage
free, so we will al ulate the premium a ording to the adjusted pa-
rameter prin iple suggested by Venter [61℄. See the latter paper for
a des ription of the premium prin iple and a dis ussion of why this
premium prin iple is arbitrage free. Let now ~1 and ~ be the adjusted
parameters and let X~t be the adjusted pro ess, i.e. X~ t is a ompound
Poisson pro ess with Poisson parameter ~1 and with marks that are
exponentially distributed with parameter ~ . . The premium is then:
Pt = EP [L~ t ℄
= EP [L0 exp(X~ t )℄
~ t
= L0 exp( 1 )
(~ 1)
Motivated by this, we will use the following model for Pt

Pt = L0 exp(1 t)
We are now ready to nd the parameter hl and thereby derive the
risk neutral measure in the loss period. hl is hosen su h that the pro-
ess fe rt Lt =Pt g is a martingale under the Ess her transformed measure
E [exp( rt)Lt =Pt ℄ = 1
) exp((r + 1 )t) = E [exp(Xt )℄
Z 1
) exp((r + 1 )t) = exp(x)F (dx; t; hl )
1
(4.7) ) exp((r + 1 )t) = M (1; t; hl )
By (4.6) it follows that the ondition for hl in the loss period is:
(4.8) exp(r + 1 ) = Ml (1; 1; hl )
where Ml denotes that it is the moment generating fun tion with re-
spe t to the distribution in the loss period. For the development period
the situation is similar, the model for Xt is just dierent, see [18℄ for
further details. The ondition for hd in the development period is:
(4.9) exp(r + 2 ) = Md (1; 1; hd )
where Md denotes that it is the moment generating fun tion with re-
spe t to the distribution in the development period.
The Radon-Nikodym derivative for the risk neutral Ess her measure
on the -algebra Ft an now be hara terized
8
dQ < ehl X t
Ml (hl ;t) t 2 [0; T1 ℄
jF =
dP t h X h (X X )
: e l T1 e d t T1
Ml (hl ;T1 ) Md (hd ;t T1 ) t 2 [T1 ; T2 ℄
where hl and hd are given by equation 4.8 and equation 4.9 respe tively.
Although there is more than one equivalent measure, the risk neutral
Ess her measure provides a unique and transparent answer. In [18℄ the
measure is justied by looking at a representative investor with a power
utility fun tion, see [18℄ for further details.
The above results is then used to al ulate the on rete risk neu-
tral Ess her measures for both the loss period and the development
period, see [18℄ for further details. Let us now onsider the PCS
all option with exer ise pri e A, ap K and expiring date T2 . Let
v1 (t) := ln(A=(L0 exp Xt )) and v2 (t) = ln(K=(L0 exp Xt )). The value
of the option at time t 2 [T1 ; T2 ℄ an then be expressed as:

C (t; Lt ) = e r(T2 t) Lt exp(2 (T2 t)) F (v2 (t); T2 t; hd + 1)

F (v1 (t); T2 t; hd + 1) + K (1 F (v2 (t); T2 t; hd ))

(4.10) A(1 F (v1 (t); T2 t; h ))
d
If t 2 [0; T1 ℄ then the value of the all option at time t is given by
C (t; Lt ) = e r(T t) E [C (T2 ; LT )jFt ℄
2
2
= e r(T t) E [E [C (T2 ; LT )jFT ℄jFt ℄

2
2 1
the value of E [C (T2 ; LT )jFT ℄ is given by (4.10). At time t < T1

2 1
the values of LT ; v1 (T1 ) and v2 (T1 ) are sto hasti . The onditional
1
mean value at time t is therefore obtained by integrating the expression
with respe t to the distribution fun tion for the risk neutral Ess her
Implied loss distributions 21
transformed pro ess in the loss period, see [18℄ for further details. Here
we al ulate the exa t pri e of the PCS-option.
5. Implied loss distributions
As we have seen in the previous se tion, it is hard to nd realisti
models for the loss index, whi h also allows one to express onsistent
pri es in a losed form.
In Christensen [19℄ we therefore lead our analysis in another dire -
tion. We follow a pro edure familiar to the onventional option market
whi h is also suggested by Lane and Mov han in [46℄. Rather than esti-
mating volatilities and al ulate onsistent pri es using, say the Bla k
S holes model, they take the traded pri es and extra t the volatilities
onsistent with those pri es, i.e. nd the implied volatility. We an-
not use the exa t same pro edure on the insuran e derivative market,
sin e we are not able to hara terize the pri e by a single parameter.
However we an do something similar. We an hoose a model for
the implied loss distribution and then estimate the implied parameters
from the observed pri es.
dierent pri es and insuran e derivative produ ts. We simply al ulate
implied pri es from the implied loss distributions and ompare them
to the observed pri es. There are two main problems related to this
analysis. First what kind of distribution should be used for the implied
loss distribution, and se ond, how should the involved parameters be
estimated. These two questions are answered in the manus ript [19℄,
where we base our analysis on data for the PCS-option. We now give
a summary of this manus ript.
5.1. The models. In [19℄ we onsider six dierent models for the im-
plied losses whi h are all presented in this se tion. Five of these models
are new. Before we present these models we rst give a general des rip-
tion of the pri e for a PCS all-spread expressed by the implied loss
distribution.
Consider now a PCS all-spread expiring at time T with upper and
lower strike Ku and Kl , respe tively. Let FeLT and feLT be the implied
distribution fun tion and the implied density fun tion for the aggregate
PCS loss index (LT ) at time T . The value of the PCS all-spread at
time 0 is then given by
PKu;Kl (L0 ; 0) = Ee [min(max(LT Kl ; 0); Ku Kl )℄
Z Ku
= (x Kl )feLT (x)dx + (Ku Kl )(1 FeLT (Ku ))
Kl
22 Implied loss distributions
The question is now, how is this implied loss distribution of the PCS
index related to the real statisti al distribution, i.e. the distribution
under the P -measure? The implied distribution for the losses and
the real distribution for the losses will in general not be the same.
But based on the dis ussion in [19℄, we only use models whi h ould
reasonably be used to des ribe the real losses, when we model the
implied losses. We now present the six models for the implied losses.
Model 1. The rst model onsidered is similar to the one suggested
by Lane and Mov han [46℄, namely a ompound Poisson model with
gamma distributed laims, i.e.
NT
X
LeT = Yi
i=1
where LeT is the implied losses, NT Pois() and Yi ( ; ). The
ni e thing about this model is that we know the nth onvolution of the
Y 's (Y1 + : : : + Yn (n ; )). This fa t makes omputations very
simple. A disadvantage of the model is that the laims are light-tailed,
whereas data give eviden e that the distribution of the aggregate laims
is heavy-tailed. In this model we an only approximate a heavy-tail by
hoosing low values of and .
It is important to have this model in the analysis in order to see how
the results from this model dier from the following new and more
ompli ated models.
Model 2. Looking at the listed all-spreads we see, that the one
with the lowest strikes is the 40/60 all-spread (see Table 5.1 below).
The bid and ask for this all-spread is 12 and 15 respe tively, whi h
are relatively large values for a produ t that has a maximum pay-out
of 20. These fa ts ould therefore indi ate that the market expe ts the
loss index to be above a given threshold K0 for sure. If this is true and
K0 > 40, then there is no market for a 20/40 all-spread, be ause the
market will expe t the all-spread to be worth 20 for sure. Based on
these indi ations we now make an extension of model 1,
NT
X
LeT = K0 + Yi
i=1
where LeT is the implied losses, K0 is a onstant indi ating the threshold
the market expe ts the losses to be above for sure, NT Pois() and
Yi ( ; ). A ording to the bid of the 40/60 all-spread (12), we
will not allow K0 to be above 52 (40+12). A possible interpretation of
this model is to think of K0 as the mean value of the \normal" laims
and of the ompound Poisson pro ess as a model of the ex esses.
Model 3. The next model will also rely on a light-tail distribution

but we will now put more u tuation into the model.
The PCS index an be viewed as the sum of losses from the individ-
ual atastrophes, and the losses from the individual atastrophe an
be viewed as the sum of the individual laims orresponding to this
parti ular atastrophe. We ould therefore model the PCS index LT
as
NT X
X Mi
LT = Yij
i=1 j =1
where NT is the number of atastrophes, Mi the number of laims from
the ith atastrophe and Yij is the laim size number j from atastrophe
number i. Re all that this model is similar to the one suggested in [17℄,
where it was used to in orporate the reporting times of the laims.
The number of laims from a atastrophe is P very large, so by the
strong law of the large numbers it follows that M j =1 Yij Mi E [Yij ℄.
i
If the approximation should be good we will also need the Var(Yij )

to be Psmall. If we use this approximation, we ould des ribe LT as
LT Ni=1T Mi Y where Y = E [Yij ℄. Motivated by this, we now model
the implied PCS index as
NT
X
LeT = Mi Y
i=1
where NT Pois(), Mi NB( ,p) or more pre isely by a mixed
Poisson distribution with a mixing parameter i ( ; ) and Y is
a onstant. We now have a model allowing for more u tuation but we
also have four parameters to estimate.
Model 4. We simply use the same model as model PNT 1, but we now
hoose a Pareto distribution for the Y 's, i.e. LT = i=1 Yi where NT
Pois() and Yi Pa(; ). However, we do not know the nth onvolu-
tion of the Y 's. We solve this problem by the following approximation.
The value of the PCS all-spread with strikes Kl and Ku at time 0 is
here given by
PKu;Kl (L0 ; 0)
1 n Z Ku Z 1

X
= e (x K )f n (x)dx + (K
l u Kl ) f n (x)dx
n=1
n! Kl Ku
4 Z Z Ku
X n 1
e
n!
(x Kl )f n (x)dx + (Ku Kl ) f n (x)dx
n=1 Ku Kl
where f n (x) denotes the density for the nth onvolution of the Pareto
distribution.
The rst 4 onvolutions are then found by the Rwell-known general
formula for R the Lebesgue
R onvolution (f 2 (x) = 0x f (x y )f (y )dy ,
f 3 (x) = 0x f (x y )( 0y f (y z )f (z )dz )dy , : : : ). By only taking the
rst 4 onvolutions in the sum it should be possible for a omputer to
al ulate the expression. And if (the average numberPof atastrophes)
is small, the approximation is good be ause the term 1 n
5 e =n! will
be small.
Model 5 This model is inspired by the volatility surfa e models
trying to explain the volatility smile, i.e. models where the implied
volatility depends on the strike of the option. We onstru t a similar
model where the most explanatory parameter in the implied loss dis-
tribution is dependent on the strike. We assume that the implied loss
index is Pareto distributed, i.e.
L~ T Pa(; )
being just a s ale parameter. The most explanatory parameter in
this loss distribution is the parameter. We therefore hoose to be
the strike dependent parameter, i.e. we assume that is a fun tion of
the strike ((K ) = f (K )). The estimation of the parameters is done
in four steps, be ause we have to hoose the fun tion f rst. The four
steps are as follows:
1. We assume that = 0 , i.e. independent of the strike. We then
let LeT P a(0 ; 0 ) and estimate the parameters 0 and 0 .
2. We now keep xed as 0 and then for ea h PCS all spread with
strikes Kli and Kui , we estimate an i from the traded pri e or the
bid/ask spread dependent of what is available. These values are
then plotted. A possible pi ture ould be the one given by gure
5.1.
3. From this plot we hoose a fun tion to des ribe our , i.e. if we
hoose a fun tion f with three parameters a, b and , a; b; 2 R.
We an now des ribe by (K ) = f (a; b; ; K ). The implied loss
distribution for a PCS all option with strike K is therefore given
by
LeT Pa((K ); )
where (K ) = f (a; b; ; K ).
4. Cal ulate the theoreti al pri es and estimate the parameters.
Model 6. The models 3, 4 and 5 ould also be extended by in luding
a threshold as was done for model 1 in model 2. But we will desist from
doing this, as model 3 and 5 will be over parameterized and model 4
-
20 40 60 80 100 120 Strike
Figure 5.1. The values.
will be too omputationally heavy. We return to this dis ussion later.

The last model we will onsider is a very simple model, whi h we expe t
to be omputationally very fast. It will be interesting to ompare the
results of this model with the results of the other more ompli ated
models. We again in lude a threshold as we did for model 2 and then
model LT by
LeT = K0 + YT
where LeT is the implied losses, K0 is a onstant indi ating the threshold
the market expe ts the losses to be above almost surely, and YT
Pa(; ). Again we will not allow K0 to be above 52.
The above six models are the models we are testing on the data
available. The next step in the analysis is to des ribe the obje tive
fun tion from whi h the parameters should be found. The obje tive
fun tion that we purpose in the next se tion is new and dierent from
the one used by Lane and Mov han in [46℄.
5.2. The obje tive fun tion. Lane and Mov han [46℄ estimate the
parameters for the implied loss distribution by the following pro edure.
\The parameters are hosen su h that they generate pri es that are
(i) lower than known oers; (ii) higher than known bids, and (iii)
losest to a tual traded pri es. The optimization is two-tier. First, get
inside the bid-oer spread. Se ond, get losest to a tual traded pri es.
The two-tier ee t is a hieved by atta hing (ideally non-Ar himedean)
weights to ea h of the two obje tive fun tions. \Closest" is dened as
the absolute value of the dieren e between the a tual traded pri e and
the theoreti al (or tted) pri es".
We agree that it is desirable that the parameters are hosen su h that
the pri es fulll (i) and (ii), but we do not think that the requirements
should be invariable, sin e it ould be a problem to nd a solution if

the spreads are very small. And if the theoreti al pri es appear to be
far away from the spread, it ould be used to indi ate that the hosen
model may be wrong. We also agree on point (iii), i.e. if our data
ontains only traded pri es, the parameters should be found by a least
square t. But the data primarily onsists of spreads and single bids
or asks, we therefore suggest the following obje tive fun tion.
X Pibid Pith + 2 X Pith Piask + 2
O = bid +
bids P i asks Piask
| {z } | {z }
term 1 term 2
1 X (Pibid ask
Pi )
+ Æ1
#spreads spreads (P bid + P ask )=2
i i
| {z }
term 3
X P th (P bid + P ask )=2 2 1
i
P
i
bid P ask
i ^4
spreads i i
| {z }
term4
X P th 2P bid + 2
+ Æ2 i i
P bid
single bids i
| {z }
term 5
X 0:5P ask P th + 2
+ Æ2 i i
P ask
single asks i
| {z }
term 6
where the Pith 's are the theoreti al pri es, the Pibid 's are the observed
bids and the P ask 's are the observed asks. Æ1 and Æ2 are both onstants.
i
When Pi is a traded pri e, Pi is onsidered as both a bid and an ask
where Pibid = Piask .
Term 1 and 2 are in luded be ause, as mentioned above, we prefer
the theoreti al pri es to be above the observed bids and below the
observed asks. And as for the optimal ase where we have only traded
pri es and no bid/ask spreads, these two terms alone will give us the
ommonly used least square t.
As long as the average length of the spreads is small, we are lose to
the optimal ase where we have only traded pri es and term 1 and 2
will probably be suÆ ient to nd a solution. But if the average length
of the spread is large there is less information about the pri es and we
will probably be unable to nd a unique solution. We therefore add
term 4. In this term we value the information from the bid and the ask
equally, i.e. we prefer the theoreti al pri e to be in the middle of the
bid/ask spread. We ap the single terms in the sum at 1/4, be ause if
Pith = Pibid or Pith = Piask the single term in the sum is equal to 1/4,
and if Pith > Pibid or Pith < Piask then it is punished in term 1 or 2. How
mu h this fourth term should be valued ompared to term 1 and 2 is
adjusted by term 3. Term 3 is a onstant Æ1 and a term denoting the
average length of the spread. In agreement with the omments above,
we thereby obtain that, if the average length of the spreads is small,
we weight Pith being in the middle less than if the average length of the
spreads is large.
The terms 5 and 6 are in luded in order to se ure that the theoreti al
pri es do not get too far away from the single bids or asks. By too far
away we mean that a theoreti al pri e is punished if it is lower than
50% of a single ask or higher than 200% of a single bid. By the term
Æ2 we are able to adjust how mu h the fth term should be valued
ompared to the other terms.
5.3. The parameter estimation. In this se tion we estimate the
parameters and evaluate the six models des ribed above. Before we
start to estimate we rst present the data.
The data material that we are going to use for this analysis are the
pri es for the National PCS all-spreads announ ed by the CBoT on
January 7th 1999.
The National PCS all-spreads announ ed by the CBoT on January
7th 1999 is given by Table 5.1.
Call-Spreads Kl =KU bid ask

National 40/60 12.0 15.0
National 60/80 6.0 12.0
National 80/100 4.0 8.0
National 100/120 2.8 4.0
National 150/200 4.3 6.0
National 200/250 2.8 4.0
National 250/300 3.5
Table 5.1. The National PCS all-spread pri es.
The rst hange in the underlying PCS index was made January
19th, where the index in reased from 0 to 7.6. We have hosen the
data from January 7th be ause the last hanges in the bids and asks
before January 19th were made here. If we take data from dates after
January 19th we have to take the value of the index into a ount. If we
onsider data from a time point t where the PCS index is greater than
0, some adjustments have to be made. The implied losses at expiration
time T an, at time t, be written as LeT = (LeT Lt ) + Lt , where Lt
is a onstant and LeT Lt is the implied losses in the period from t
to T . LeT Lt an then be des ribed by the same models as we used
to des ribe LeT , but the parameters will probably be hanged. Even
though we are looking at a model where LeT is a stationary pro ess, we
annot expe t the same parameters sin e the PCS index is in uen ed
by some large seasonal ee ts.
The parameters are found by minimizing the obje tive fun tion, with
Æ1 = 0:001 and Æ2 = 0:1. We return to the dis ussion of these parame-
ters later. The obje tive fun tion is a fun tion depending on a higher
dimensional variable (the dimension is given by the number of param-
eters in the model). We therefore hoose to minimize it by using a
modi ation of the method of steepest des ent des ribed by Broyden
see [8℄ and [35℄.
The parameters found by minimizing the obje tive fun tion, the or-
responding mean values and varian es for the implied losses and the
theoreti al pri es are listed in table 5.2, table 5.3 and table 5.4, respe -
tively.
Model par. 1 par. 2 par. 3 par. 4 value

1 = 70 = 0:0123 = 0:0129 0.058
2 = 55 = 0:0050 = 0:0039 x = 47:2 0.00015
3 = 36 = 0:00019 = 0:0266 Y = 0:015 0.086
4 = 2:6 = 3:50 = 90:7 0.060
5 = 58 a = 0:117 b = 4:082 = 0:596 0.013
6 = 24 = 1:25 x = 40:0 0.00010
Table 5.2. The estimated parameters.
M1 M2 M3 M4 M5 M6
Mean value 74 90 77 96 (73;91) 139
Varian e 6096 8453 6178 11652 1 1
Table 5.3. Mean value and varian e of implied losses.
Kl =KU bid M1 M2 M3 M4 M5 M6 ask

40/60 12.0 9.87 13.56 10.02 9.33 13.57 13.57 15.0
60/80 6.0 7.61 6.55 7.72 7.27 8.00 7.48 12.0
80/100 4.0 5.88 4.82 5.96 5.63 5.49 5.03 8.0
100/120 2.8 4.55 3.78 4.60 4.36 4.07 3.73 4.0
150/200 4.3 5.07 5.07 5.06 4.92 5.08 4.88 6.0
200/250 2.8 2.71 3.35 2.67 2.78 3.41 3.45 4.0
250/300 1.45 2.29 1.41 1.67 2.46 2.64 3.5
300/350 0.78 1.60 0.74 1.06 1.87 2.11 3.0
Table 5.4. The theoreti al pri es.
A detailed dis ussion of these results an be found in [19℄. We now

give the main on lusion. From Table 5.4 we see that model 1 is unable
to generate pri es that get into the bid/ask spread of the 40/60 and
200/250 all-spreads and we also see that it produ es very low pri es
for the 250/300 and 300/350 all-spreads. This indi ates that model
1 is a bad des ription of the implied losses. But re all that this is the
model that was su essfully suggested by Lane and Mov han in [46℄ so
why now this dieren e? In [46℄ they onsider market pri es midyear
1998 where the PCS index was nearly 40 and this apparently makes a
dieren e.
We also tried to model the midyear 1998 pri es with model 1 and
our obje tive fun tion. The results are shown in Table 5.5 (The
parameter from [46℄ has been adjusted to orrespond to the index value
and not the Billion $ value).
From Table 5.5 we see that model 1 in our obje tive fun tion also
generates reasonable results for the midyear 1998 pri es. We therefore
on lude that the reason for the bad t of the 1999 pri es is the model
and not the obje tive fun tion. Another important thing to note from
Table 5.5 is that there are remarkable dieren es in the pri es obtained
by Lane and Mov han and the pri es we obtain. We thereby see that
the valuation of the bids and asks is highly dependent on the hoi e of
the obje tive fun tion.
Instead, we nd that model 2 is a better model to use for the implied
losses. However, it would be preferable to use model 6 also in order
to support model 2. It is lear that none of the suggested models t
the implied losses perfe tly, but we believe that model 2 supported by
model 6 will be a good tool for investors analysing pri es of atastrophe
insuran e derivatives. Models 3, 4 and 5 are all bad des riptions of the
losses for various reasons, see [19℄ for further details.
Kl =KU bid LM CVC ask

40/60 11.0 11.0 12.0
60/80 6.0 7.5 8.2 10.0
80/100 5.7 6.1 8.0
100/120 3.5 4.4 4.6 6.0
100/150 9.4 9.5 12.0
120/140 1.0 3.5 3.5 6.0
250/300 0.5 1.9 1.4 2.5
100/200 14.7 14.4 20.0
150/200 4.0 5.4 4.9 7.5
180/200 0.4 1.8 1.6 1.8
2.23 2.17
0.1887 0.2645
0.0089 0.0124
Table 5.5. The data from [46℄ ontra our data.
In relation to how the parameters should be estimated we nd that an

improvement of the pro edure from [46℄ was ne essary for the following
two reasons. Firstly we agree that it is desirable that the parameters
are hosen su h that the pri es are lower than known oers and higher
than known bids, but we do not think that the requirements should be
invariable be ause, if the spreads are very small, it ould be a problem
to nd a solution. And if the theoreti al pri es appear to be far away
from the spread, it ould be used to indi ate that the hosen model may
be wrong. Se ondly we agree on point that the parameters should be
hosen su h that the pri es gets losest to the a tual traded pri es, i.e.
if our data ontain only traded pri es, the parameters should be found
by a least square t. But be ause the data primarily onsists of spreads
and single bids or asks, we nd that this should be in orporated in the
obje tive fun tion. No matter what obje tive fun tion one uses, it is
lear from the dis ussion of model 1 that the hoi e of the obje tive
fun tion has a large ee t on the derived pri es, and it should therefore
be hosen arefully.
5.4. Other relevant referen es. Let us end this se tion with a short
des ription of some other interesting papers in relation to insuran e
derivatives. There is a huge amount of literature on the subje t, a lot
of it being non-mathemati al, e.g. [11℄, [36℄, [57℄ and [60℄. From the
more mathemati al papers let me shortly des ribe the following three.
The future of global reinsuran e 31
Firstly, Bro kett, Cox and Smith, [7℄ use a more a tuarial pri ing
approa h. They assume that the traders do not have omplete infor-
mation about the underlying loss pro ess, but only information about
a range of values for the loss pro ess, i.e.
1 E [LT ℄ 2 and 12 V ar[LT ℄ 22
Based on this information they are then able to derive a range of pri es
for the insuran e derivatives, see [7℄ for further details.
Se ond, Rasmussen, [50℄, develops along the line of S hweizer, [56℄,
and uses the minimal martingale measure to pri e the PCS option. In
[50℄ it is shown that the equivalent minimal martingale measure exists
and it is shown how one an nd the fair hedging pri e of a PCS option
by hoosing the equivalent minimal martingale measure as the pri ing
measure.
Finally, we mention the paper by S hmo k, [54℄. This paper onsid-
ers atastrophe bonds issued by Winterthur. Several dierent models
are presented in order to evaluate the value of the oupons, and it is
shown how substantial the model risk, inherent in pri ing su h nan ial
produ ts, is.
6. The future of global reinsuran e
In this se tion we will take a look into the future of global reinsur-
an e. The results in this se tion are based on Christensen [20℄.
Risk related to natural phenomena su h as various atastrophes has
traditionally been distributed through the insuran e and reinsuran e
system. Insuran e ompanies a umulate the risk of individual entities
and redistribute the risk to the global reinsuran e industry. But, as
dis ussed earlier, it will be insuÆ ient to manage this risk in su h a
way in the future. A new way to managing su h risk or unknown risk
in general is alled for.
When we talk about unknown risk, we refer to risk whose frequen y
we do not know, i.e. there is more than one estimate of the frequen y
of the risk. Examples of unknown risk are environmental health risk of
new and little known epidemi s, or risk indu ed by s ienti un ertainty
in predi ting the frequen y and severity of atastrophi events.
The problems related to unknown risk was rst mentioned by Chi-
hilnisky and Heal in [15℄ (a non mathemati al paper), where they
argued that unknown risk should be managed by using traditional in-
suran e pra ti e and by trading in the se urity market simultaneously.
In the arti le [20℄ we ontinue and extend the ideas from [15℄. The
main purpose is to build a mathemati al model that is able to handle
these problems.
32 The future of global reinsuran e
In the following we will des ribe the mathemati al model from [20℄
and explain how we extend the ideas from [15℄ by onsidering both
omplete and in omplete markets and by onsidering the ase where
the premium harged by the insuran e ompany is restri ted.
In [20℄ we onsider a general model for an insuran e ompany, where
the ompany fa es n states of the world. For ea h of these states the
insuran e ompany is able to estimate the frequen y of the risk, but
the risk related to the states is unknown. We show how the ompany
should handle this unknown risk. This is done by using the statisti al
approa h to handle the known risk, i.e. the risk related to a given state,
and by using the e onomi approa h to handle the risk related to the
dierent states.
6.1. The model. Let S denote the state of the world. We make the
following assumptions:
There are n states denoted by fs1; : : : ; sng; S 2 fs1; : : : ; sng.
The probabilities orresponding to the n states are known
n
X
P (S = si ) = pi ; i = 1; : : : ; n; pi = 1
i=1
Fi is known for all i 2 f1; : : : ; ng, where Fi denotes the distribu-
tion of the loss (L) of the insuran e ompanies, given the state is
i (LjfS = si g Fi ). Let Li = LjfS = si g.
If the insuran e ompany knows the state S , then the statisti al
approa h by adding a safety loading would work, i.e. if the insur-
an e ompany knew that S = si , it would be reasonable to harge
the premium Pi given by
Pi = E [Li ℄ + Æi
where Æi is a safety loading al ulated by a standard premium
al ulation prin iple.
There exist n \state se urities" traded on the n states. Se urity
number j pays the amount ij if the state is i. Let i be the ve tor
i = ( i1 ; : : : ; in) and let C be the matrix given by
2
1 3
C = 4 ... 5
n
Let further ~j be the j th olumn in C .
The market is omplete, i.e. the n olumns in C are linearly inde-
pendent.
The market for these se urities is arbitrage free and there exists a
unique risk neutral measure. We denote the risk neutral probabili-
ties by q1 ; : : : ; qn , and let q be the ve tor given by q = (q1 ; : : : ; qn ).
From basi nan e ourses it is known that these risk neutral prob-
abilities an be used to pri e the state se urities, i.e. the pri e of
state se urity number i is given by the dis ounted value of q ~j .
There exists a risk free se urity and for simpli ity we assume that
the risk free interest rate is zero. This is no loss of generality,
sin e we an dis ount all se urities.
We now have a model where the insuran e ompany exa tly knows
how they should handle the insuran e risk if the state of the world is
known. But be ause of the un ertainty about the state of the world,
the general risk for the insuran e ompany be omes unknown. In the
next se tion we will show how the insuran e ompany is able to handle
this unknown risk.
6.2. How to handle unknown risk in a omplete market. The
expe ted loss for the insuran e ompany is given by
E [L℄ = p1 E [L1 ℄ + + pn E [Ln ℄
To over these losses, the insuran e ompany has to harge a premium
P . But harging a premium is not enough, sin e we obtain a safety
loading in state i given by Æ~i = P E [Li ℄ if the insuran e ompany
harges a premium P . The problem onne ted with this, is that we do
not obtain the desired safety loading. For some i's we have that Æi < Æ~i
whi h means that the insuran e ompany has been over harging. And
for some i's we have that Æi > Æ~i , whi h means that the insuran e
ompany has been under harging, whi h ould lead to a dangerous
position. Before we solve this problem, we make the two following
denitions.
Denition 6.1. A trading strategy for the insuran e ompany is
dened as a ve tor m = (m1 ; : : : ; mn )T where mi denotes how many
se urities i the insuran e ompany buys.
Denition 6.2. An optimal trading strategy for the insuran e
ompany is a ostless trading strategy su h that
(6.1) P + i m E [Li ℄ = Æi 8i = 1; ; n:
The questions are now whether it is possible to obtain this optimal
strategy and if so, what premium should be harged in order to obtain
it? These questions are answered in the following theorem.
Theorem 6.1. An optimal trading strategy an be obtained if and only

if
P = q1 P1 + + qn Pn :
In this ase, the strategy m has to be hosen by
2
P + E [L1 ℄ + Æ1 3
m = C 14 .. 5:
.
P + E [Ln ℄ + Æn
Remark 6.1. The problem an be simplied onsidered in the following
way. The insuran e ompany wants to obtain the premiums (P1 ; : : : ; Pn )
orresponding to the n states. This ould be obtained for all i if we
for all i buy Pi of Arrow-Debreu (AD) se urity number i. AD se urity
i is a se urity that pays 1 if the state is i and pays zero in all other
states. These AD se urities exist be ause the market is omplete, and
the pri e of AD se urity number i is given by qi . The total pri e of this
AD portfolio is therefore given by
n
X
Total pri e = Pi qi
i=1
Pn
So by harging a premium P = i=1 Pi qi ,
the insuran e ompany an
obtain the optimal strategy. This only works if the market is omplete,
we will return to the in omplete ase later.
6.3. The restri ted premium ase. In the previous se tion we found
the optimal premium to harge for the insuran e ompany. But the
insuran e ompany may be unable to harge this premium for ompe-
tition reasons. We therefore now assume that the premium whi h the
insuran e ompany an harge is xed at P0 .
The insuran e ompany should therefore hoose a trading strategy
whi h they nd \optimal" under the restri tion that the ost of the
trading strategy equals P0 . What we mean by \optimal" is dis ussed
later in this se tion. In this omplete market ase, hoosing a trading
strategy m is equivalent to hoosing premiums (P1 ; : : : ; Pn). We have
the following relation between (P1 ; : : : ; Pn ) and m
(P1 ; : : : ; Pn )T = Cm:
The restri tion an also be expressed in terms of the Pi 's instead of m.
vm = P0
) qCC 1 (P1; : : : ; Pn)T = P0
) q1 P1 + + qnPn = P0 :
These observations allow us to reformulate the problem to a problem

in terms of the premiums (P1 ; : : : ; Pn ) instead of a problem in terms
of the trading strategy m.
The problem in this xed premium ase is therefore to nd the \opti-
mal" hoi e of the Pi 's subje t to the onstraint P0 = P1 q1 + + Pnqn .
In [20℄ we onsider four dierent ways of solving this optimal premium
hoi e (OPC), i.e. dening \optimal". The four OPC's are based on
the following:
OPC1: The goal here is to obtain the same risk quantity in all
the states. To measure the risk quantity, we will use the mean
divided by the standard deviation.
OPC2: The goal here is to obtain the same ruin probabilities in
all the states.
OPC3: The goal here is to obtain the same expe ted utility in all
the states.
OPC4: The goal here is to obtain the maximal expe ted utility.
In [20℄ these four OPC's are solved, analysed and ompared, see [20℄
for further details.
6.4. The in omplete market ase. In this se tion we onsider the

in omplete market ase, i.e. a market where the number of states n
is larger than the number of se urities. Now let k denote the number
of se urities. Let again vi be the pri e of state se urity number i and
let v = (v1 ; : : : ; vk ). Be ause of the in ompleteness in this market
we are no longer able to onstru t the n AD se urities. We therefore
annot onstru t the optimal trading strategy and set the premium
by P = q1 P1 + + qn Pn . So instead of onstru ting the optimal
trading strategy an alternative ould be to hoose the heapest strategy
whi h assures that the premium in state i is greater than or equal to
Pi = E [Li ℄ + Æi for all states, i.e. hoose a trading strategy that solve
the following problem
min
m
vm
k
X
st mj ij E [Li ℄ + Æi i = 2; : : : ; n:
j =1
A problem of this strategy is that it ould be very expensive. An

alternative strategy is therefore to hoose the premiums so that they get
as lose as possible to the optimal premiums (P1 ; : : : ; Pn ), i.e. hoose
the portfolio m that solves the following problem

n X
X k
min
m1 ;::: ;mk
( mj ij Pi )2
i=1 j =1
or equivalently
2
P1 3
min
m
kCm 4 ... 5 k2
Pn
where C now is a n k matrix. This is a well known problem and it is
solved by the least square solution whi h is given by, (see [3℄ p. 318),
2
P1 3
m = (C T C ) 1 C T 4 ... 5
Pn
After these onsiderations we now make the following denition
Denition 6.3. A least square strategy is a trading strategy su h
that the insuran e ompany gets as lose as possible to the desired n
state premiums as possible in the least square sense, i.e. the least
square strategy is obtained by the following portfolio of se urities.
2
P1 3
m = (C T C ) 1 C T 4 ... 5
Pn
The insuran e ompany would of ourse prefer to follow the optimal
trading strategy given by Pi = E [Li ℄ + Æi but this is impossible in this
market. But had it been possible the insuran e ompany would have
been willing to pay more for the optimal strategy than for the least
square strategy. Therefore, if the insuran e ompany follows the least
square strategy they should harge a premium that is larger than the
pri e of the least square strategy. They are thereby ompensated for
not having the optimal strategy but only the least square strategy.
Let us now as in the omplete ase onsider the situation where
the insuran e ompany is unable to harge the desired premium for
ompetition reasons. We again set the possible xed premium that
an be harged to P0 .
The problem now is that we want to set the Pi 's a ording to OPC1,
OPC2, OPC3 or OPC4 but the equation P0 = P1 q1 + + Pn qn is no
longer valid. We are no longer able to onstru t the n AD se urities
in this in omplete market. But instead of hoosing the Pi 's a ording
to OPC1, OPC2, OPC3 or OPC4, we ould hoose the orresponding
Con lusion 37
least square solution. We would then just have to repla e the equation
P0 = P1 q1 + + Pn qn with an equation that makes sure that the
pri e of the least square portfolio is equal to P0 . How this is done is
des ribed in [20℄, see [20℄ for further details.
7. Con lusion
What have we done in this thesis? Or perhaps more a urately:
What are the ontributions of the manus ripts in luded?
Christensen and S hmidli [17℄ present a model for insuran e fu-
ture pri ing, whi h only relies on the information available. The prod-
u ts are pri ed solely from observing the reporting stream. Contrary
to the existing literature we model the reporting times expli itly. We
thereby obtain a more realisti model.
The results of this arti le rely on an approximation of the exa t future
pri e. One therefore has to be areful applying the results derived,
be ause the results will be ina urate if the ap-probability (P (LT > 2
2)) or the risk aversion oeÆ ient is \too large".
This paper suggests two ways of approximating the approximation
error, the gamma approximation and the Edgeworth approximation.
It is shown that they are both useful in the determination of the error
level even though the gamma approximation seems to be the best.
Christensen [16℄ is a gathering of information about the PCS-
option. It explains why the PCS-option repla ed the CAT-future and
how the PCS-option is an improvement. The paper also explains how
to hedge atastrophe risk with PCS-options and it ompares the PCS-
option with traditional reinsuran e.
Christensen [18℄ derives a new model for pri ing insuran e deriva-
tives whi h allows for heavy-tails, and also provides a unique pri ing
measure. The model is obtained by modeling the logarithms of the loss
pro ess as a ompound Poisson pro ess with exponential distributed
marks in the loss period and with normal distributed marks in the de-
velopment period. The pri e is found by evaluating the future pay-out
of the insuran e derivative under the risk neutral measure derived by
the Ess her approa h. In the arti le the exa t pri e in the ase of the
PCS-option is al ulated.
Christensen [19℄ analyses pri es for atastrophe insuran e deriva-
tives by looking at the \implied loss distributions" embedded in the
traded pri es. And it gives answers to the two main problems in this
analysis. First, what kind of distribution should be hosen for the
implied losses and se ond, how should the involved parameters be es-
timated?
38 Con lusion
In relation to how the parameters should be estimated we have ome

up with a new obje tive fun tion. It is not possible to prove that it is
better than the one used by Lane and Mov han [46℄, but we nd that
the argumentation in the paper supports the hoi e of the proposed
fun tion.
In the paper it is also do umented that the model suggested by Lane
and Mov han [46℄ is unable to t the PCS-option pri es in general.
Instead the manus ript suggests other models, some of whi h are shown
to be more suÆ ient in the des ription of the implied losses.
Christensen [20℄ presents a model for managing unknown risk. The
model is inspired by Chi hilnisky and Heal [15℄ (a non mathemati al
paper), where they argued that unknown risk should be managed by
using traditional insuran e pra ti e and by trading in the se urity mar-
ket simultaneously. The model presented in [20℄ is new and it presents
the ideas from [15℄ in a mathemati al way, i.e. [20℄ show how unknown
risk and related problems an be handled mathemati ally.
[20℄ also extends the ideas from [15℄ by onsidering both omplete
and in omplete markets. Furthermore it onsiders the ase where the
premium harged by the insuran e ompany is restri ted. In this ase
the insuran e ompany has to hoose an allo ation of the restri ted
premium orresponding to the states of the world. We propose four
dierent methods of solving this problem. These four methods are
then analysed and evaluated, and by examples, advantages and disad-
vantages are illustrated.
Referen es 39
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[2℄ Albre ht, P., A. Konig, and H.D. S hradin (1994): Katastrophenversi-
herungsterminges hafte: Grundlagen und Anwendungen im Risikomanage-
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[3℄ Beauregard, R.A. and Fraleigh, J.B. (1990), Linear Algebra, 2nd Edition,
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Reports No. 388, Department of Theoreti al Statisti s, University of Aarhus.
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Springer-Verlag, New York.
[7℄ Bro kett, P.L., S.H. Cox and J. S hmidt (1997): Bonds on the pri e of atas-
trophe insuran e options on future ontra ts. Pro eedings of the 1995 Bowles
Symposium on Se uritization of Insuran e Risk, Georgia State University, At-
lanta. SOA Monograph M-FI97-1, p. 1-7.
[8℄ Broyden, C.G. (1970), The onvergen e lass of double-rank minimization al-
gorithms, J. Inst. Math. Appl.
[9℄ Buhlmann, H. (1980): An e onomi premium prin iple. ASTIN Bulletin 11
(1), 52-60.
[10℄ Buhlmann, H. (1984): The general e onomi premium prin iple. ASTIN Bul-
letin 14 (1), 13-21.
[11℄ Chanter, M.S., J.B. Cole and R.L. Sandor (1996): Insuran e Derivatives: A
New Asset Class for the Capital Market and A New Hedging Tool for the
Insuran e Industry. The Journal of Derivatives - Winter 1996.
[12℄ Chanter, M.S. and J.B. Cole (1997): The Foundation and Evolution of the
Catastrophe Bond Market: Catastrophe Bonds. Global Reinsuran e - Septem-
ber 1997.
[13℄ Chang, C.W., J.S.K. Chang and M. Yu (1996): Pri ing Catastrophe Futures
Call Spreads: A Randomized Operational Time Approa h. The Journal of Risk
and Insuran e, 1996, Vol. 63, No. 4. 599-617.
[14℄ The Chi ago Board of Trade (1995): A User's Guide, PCS-options.
[15℄ Chi hilnisky, G. and Heal, G. (1998), Managing Unknown Risks, The future of
Global Reinsuran e, The Journal of Portfolio Management, pp 85-91, summer
1998.
[16℄ Christensen, C.V. (1997): The PCS Option: an improvement of the CAT-
future. Manus ript, University of Aarhus.
[17℄ Christensen, C.V. and H. S hmidli (1998): Pri ing atastrophe insuran e
produ ts based on a tually reported laims. to appear in Insuran e: Mathe-
mati s and E onomi s.
[18℄ Christensen, C.V. (1999): A new model for pri ing atastrophe insuran e
derivatives. Working paper Series No. 28, Centre for Analyti al Finan e.
[19℄ Christensen, C.V. (2000): Implied loss distributions for atastrophe insuran e
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40 Referen es
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Manus ripts 43
Manus ripts
Paper I: Pri ing atastrophe insuran e produ ts based on a tually
reported laims, 17 pages.
Paper II: The PCS-option, an improvement of the CAT-future,

11 pages.
Paper III: A new model for pri ing atastrophe insuran e derivatives,
15 pages.
Paper IV: Implied loss distributions for atastrophe insuran e

derivatives, 19 pages.
Paper V: How to hedge unknown risk, 23 pages.

PRICING CATASTROPHE INSURANCE PRODUCTS
BASED ON ACTUALLY REPORTED CLAIMS
CLAUS VORM CHRISTENSEN AND HANSPETER SCHMIDLI
Abstra t. This arti le deals with the problem of pri ing a nan-
ial produ t relying on an index of reported laims from atastro-
phe insuran e. The problem of pri ing su h produ ts is that, at a
xed time in the trading period, the total laim amount from the
atastrophes o urred is not known. Therefore one has to pri e
these produ ts solely from knowing the aggregate amount of the
reported laims at the xed time point. This arti le will propose a
way to handle this problem, and will thereby extend the existing
pri ing models for produ ts of this kind.
1. Introdu tion
Modelling laims from a atastrophe a tuaries use heavy tailed dis-
tributions, su h as the Pareto distribution. This means that the aggre-
gate laim basi ally is determined by the largest laim, see [8℄ or [13℄.
This ee t be ame learly visible in the early 90's, when the insuran e
industry had to over huge aggregate laims in urring from atastro-
phes. Be ause ertain atastrophi events like earthquakes, hurri anes
or ooding are typi al for some areas, a properly al ulated annual
premium would be nearly as high as the loss insured. From an a tu-
arial point of view, su h events are not insurable. But people living in
su h areas need prote tion. One possibility would be the government
(tax payer) to take over the risk, as it is the ase for ooding in the
Netherlands. Another possibility are futures or options based on a loss
index. Here the risk is transfered to private investors. A des ription of
these produ ts an be found for example in [2℄ or [14℄.
In 1992 the Chi ago Board of Trade (CBoT) introdu ed the CAT-
futures. This future is based on the ISO-index, whi h measures the
amount of laims o ured in a ertain period and reported to a par-
ti ipating insuran e ompany until a ertain time. The produ t never
be ame popular among private investors. The reasons were that the
index only was announ ed on e before the settlement date, there was
information asymmetry between insurers and investors, and that there
1991 Mathemati s Subje t Classi ation. 62P05.
Key words and phrases. Insuran e futures; Derivatives; Claims-pro ess; Catas-
trophe insuran e; Mixed Poisson model; Change of measure; Expe ted utility;
Approximations.
1
2 C. VORM CHRISTENSEN AND H. SCHMIDLI
was a la k of realisti models. In 1995 the CAT-future was repla ed

by the PCS-option. This option is based on a loss index | the PCS-
index | estimated by an independent authority. The latter index is
announ ed daily. In this paper we study a model for indi es like the
ISO-index or the PCS-index. In the ase of the CAT-future where
the information stream is generated by a delayed reporting of laims
from the atastrophes, in the ase of the PCS-option by more and
more rened estimates. For simpli ity we will formulate the model as
a model for the ISO-index. More spe i ally, we study the ase where
the number of laims from a single atastrophe has a xed distribu-
tion (Se tion 3.1) and thereafter the ase where the number of laims
depend on an unobserved \severity" of the atastrophe (Se tion 3.2).
The re ently introdu ed PCS-options (see [5℄) do not dire tly depend
on reported laims. But there is a strong orrelation between a tually
reported laims and the PCS-index. Be ause these options serve as
a sort of reinsuran e instrument, an insuran e ompany exposed to
atastrophi risk would have to estimate the PCS-index and its pri e in
order to determine their hedging strategy. It therefore seems natural to
use the information on the laims reported to this ompany. Therefore
our (ISO-index) model may also be of interest for a ompany investing
into the new atastrophe options.
The main purpose of this arti le is to introdu e a model taking re-
porting lags into a ount. As illustration, how al ulations an be done
in this model, we will approximate the CAT-future pri e, even though
this produ t is not traded anymore. For pri ing the atastrophe in-
suran e futures and options we use the exponential utility approa h
of [1℄, [4℄ or [9℄. This approa h will only work for aggregate laims
with an exponentially de reasing tail. But data give eviden e that
the distribution tail of the aggregate laims is heavy tailed. In our
model a heavy-tail an be obtained by a heavy-tailed distribution for
the number of individual laims of a single atastrophe. For pri ing
we approximate the laim number distribution by a negative binomial
distribution; more pre isely, by a mixed Poisson distribution with a
( ; )-mixing distribution. Choosing and small a heavy-tail be-
haviour an be approximated. The reader should note that the value
of the se urity is based on a apped index and therefore has an upper
bound. This justies the light-tail approximation.
In the remaining parts of this introdu tion we des ribe the CAT-
future. In Se tion 2 we introdu e the model. In ontrast to the exist-
ing literature, the reporting lags are expli itly taken into a ount. In
Se tions 3.1 and 3.2 we al ulate approximations to the pri es. Finally,
in Se tion 4 we study the approximation error.
1.1. Des ription of the CAT-futures. CAT-futures are traded on
a quarterly y le, with ontra t months Mar h, June, September, and
PRICING CATASTROPHE INSURANCE PRODUCTS 3
De ember. A ontra t for a alendar quarter ( alled the event quarter)

is based on losses o urring in the listed quarter and being reported
to the parti ipating ompanies by the end of the following quarter. A
ontra t also spe ies an area and the type of laim to be taken into
a ount. The additional three months following the reporting period is
attributable to data pro essing lags. The six months period following
the start of the event quarter is alled reporting period. The three
reporting months following the event quarter are to allow for settlement
lags that are usual in insuran e. The ontra ts expire on the fth day
of the fourth month following the end of the reporting period. We will
use arbitrary times T1 < T2 for the end of the event quarter and the end
of the reporting period, respe tively. This will allow for redesigning the
futures. As a matter of fa t a longer reporting period would be mu h
more suitable for the need of the insuran e world.
The settlement value of the ontra t is determined by a loss index;
the ISO-index. Let us now onsider the index. Ea h quarter approxi-
mately 100 Ameri an insuran e ompanies report property loss data to
the ISO (Insuran e Servi e OÆ e, a well known statisti al agent). ISO
then sele ts a pool of at least ten of these ompanies on the basis of
size, diversity of business, and quality of reported data. The ISO-index
is al ulated as the loss-ratio of this pool
ISO-index = :
earned premiums
The list of ompanies whi h are in luded in the pool is announ ed by
the CBoT prior to the beginning of the trading period for that on-
tra t. The CBoT also announ es the premium volume for ompanies
parti ipating in the pool prior to the start of the trading period. Thus
the premium in the pool is a known onstant throughout the trad-
ing period, and pri e hanges are attributable solely to hanges in the
market's expe tation of loss liabilities.
The settlement value for the CAT-futures is
FT = 25 000 min(IT ; 2)
2 2
where IT is the ISO-index at the end of the reporting period, i.e. the
2
ratio between the losses in urred during the event quarter and reported
up till three months later and the premium volume for the ompanies
parti ipating in the pool.
Example 1.1. The June ontra t overs losses from events o urring
in April, May and June and are reported to the parti ipating ompanies
by the end of September. The June ontra t expires on January 5th,
the following year. The ontra t is illustrated by Figure 1.1.
1.2. The CAT-future pri ing problem. Cummins and Geman [7℄
were the rst to pri e the insuran e futures. Their approa h was quite

EVENT QUARTER
REPORTING PERIOD
Figure 1.1. June CAT-Future ontra t
dierent from the approa h used in this paper. As model they used
integrated geometri Brownian motion. This allowed them to apply
te hniques arising from pri ing Asian options. The model, however,
seems to be far from reality. At times where a atastrophe o urs or
shortly thereafter, one would expe t a strong in rease of the loss index.
It therefore is preferable to use a marked point pro ess as it is popular
in a tuarial mathemati s.
The pri e to pay for the more realisti model is \non-uniqueness" of
the market, see [1℄ and [9℄ for further details. In fa t, the index (It ) is
not a traded asset. Thus markets annot be omplete. Moreover, as it
is the ase for term stru ture models, any equivalent measure may be
used for no-arbitrage pri ing. However, the preferen es of the agents
in the market will determine whi h martingale measure applies.
In this arti le we follow the approa h of Embre hts and Meister [9℄.
There the general equilibrium approa h is used, where all the agent's
utility fun tions are of exponential type. More pre isely, let Ft be the
pri e of the future, Lt the value of the losses o ured in the event quar-
ter and reported till time t, Ft the information at time t, premiums
earned and let = 25 000=. Then the pri e at time t, is (see [9, p.19℄)
E [exp(L1 ) (LT ^ 2) j Ft ℄
Ft = P :
2
(1.2)
EP [exp(L1) j Ft ℄
In parti ular, EP [exp(L1 )℄ has to exist. The market will determine
the risk aversion oeÆ ient .
The term exp(L1 )=EP [exp(L1)℄ is stri tly positive and integrates
to one. Thus it is the Radon-Nikodym derivative dQ=dP of an equiv-
alent measure. In the spe i model we will onsider, the pro ess (Lt )
follows under to the measure Q the same model (but with dierent pa-
rameters) as under P . We will use this fa t to al ulate the pri e of the
CAT-future and the PCS-option. This hange of measure is similar to
the Ess her method des ribed in [11℄ and [14℄. If we assume that pro-
portional reinsuran e is possible, the premiums are fairly split between
insurer and reinsurer, and that the proportion held in the portfolio an
be hanged at any time, then the index (L1 (T ) (T )) would be ome
a traded asset, where L1 (T ) are all the laims o ured till time T and
(T ) are the premiums earned to over the laims o uring till time T .
In our model (T ) would be a linear fun tion. This would imply that
the pro ess (L1 (T ) (T ) : T 0) is a martingale under the pri ing
measure. This ondition will determine the risk aversion oeÆ ient ,
see for instan e [15℄.
To pro eed further in the al ulation of the future pri e, one has to
hoose a model for (Lt ). [1℄ used a ompound Poisson model. This
an be seen as atastrophes o urring at ertain times and laims are
reported immediately. In su h a model there would not be a need
for the prolonged reporting period. In [9℄ a doubly sto hasti Poisson
model is introdu ed. Here, a high intensity level will o ur shortly after
a atastrophe, where more laims are expe ted to be reported. In [12,
Example 5.3℄ the asymptoti expe ted value and asymptoti varian e
for a general ompound pro ess are obtained.
The aim of this paper is to model the laims reported to the om-
panies as individual laims with a reporting lag. This is done by mod-
elling the aggregate laim from a single atastrophe as a ompound
(mixed) Poisson model. We thereby obtain the possibility to separate
the individual laims and to model the reporting times of the laims.
In Se tion 3.1 we al ulate the future pri e using a ompound Pois-
son model, whereas in Se tion 3.2 the results are extended by using a
ompound negative binomial model, represented as a mixed ompound
Poisson model. We thereby an estimate the mixing parameter from
the reporting ow.
2. The model and assumptions

Let T1 denote the end of the event period and T2 > T1 the end of the
reporting period. We work on a omplete probability spa e (
; F ; P )
ontaining the following random variables and sto hasti pro esses:
Lt : The aggregate amount of reported laims till time t;
Nt : The number of at. o urred in the interval [0; t℄,
Mi : The number of laims from the i-th at.
Mi (t) : The number of laims from at. i reported until t;
Yij : The laim size for the j -th laim from the i-th at.
Dij : The reporting lag for the j -th laim from the i-th at.
i : The o urren e time of the i-th at.
We assume the following:
(Ft) is the smallest right ontinuous omplete ltration, su h that
the aggregate amount of reported losses Lt at time t is (Ft )-
adapted.
(Nt ) is a Poisson pro ess with rate 2 (0; 1).
(Mi : i 2 IIN), (Nt : 0 t T1), (Dij : i; j 2 IIN), (Yij : i; j 2 IIN)
are independent.
Mi is mixed Poisson distributed with mixing distribution F. That

is, there are random variables (i ) with distribution F su h that,
given i , Mi is onditionally Poisson distributed with parameter
i . If the distribution F is degenerated (i = for some onstant
) the (un onditional) distribution of Mi is Poisson with param-
eter . If F is degenerate then Mi is Poisson distributed. We
denote by i the mixing parameter and by a generi random
variable for i .
(i : i 2 IIN) are iid and independent of (Nt ), (Dij ), (Yij ).
Dij FD , Yij FY . We denote by Y (D, respe tively) a generi
variable for Yij (Dij ), and by mY (r) = E [erY ℄ the moment gener-
ating fun tion of the laim sizes.
The j -th laim Yij from the i-th atastrophe is reported at time
i + Dij .
We have NT Nt Poi((T t)) and (Nt +1 ; : : : ; NT j NT Nt = n)
has the same distribution as (U(1) ; : : : ; U(n) ) where the (Ui ) are iid
uniformly distributed on the interval [t; T ℄ and (U(i) ) denotes the or-
der statisti s, see for instan e [13, Thm 5.2.1℄. Moreover, it an be
shown, whi h may seem a little bit surprising, that the number of
laims Mi (T2 ) Mi (t) from atastrophe i reported in the period [t; T2 ℄
is, given i , onditionally independent of the number of laims Mi (t)
reported in the period [i ; t℄. Moreover, for 1 i NT , given (i ), i ,
1
we have

i Nt : Mi (t) i ;i Poi(i (FD (t i ))) (2.1)
and
Mi (T2 ) Mi (t) i ;i Poi(i (FD (T2 i ) FD (t i ))) ;

i > Nt : Mi (T2 ) Mi (t) i ;i Poi(i (FD (T2 i ))) :
In our model the laims Yij from the i-th atastrophe are randomly
ordered. This simplies the modelling of the reporting lags Dij . Let
(Di:j : 1 j Mi ) be the order statisti s of the (Dij )1j Mi , and Yi:j
be the laim orresponding to Di:j . Then the laims o ured before T1
and reported till t T2 amount to
Nt^T1 Mi (t)
X X
Lt = Yi:j :
i=1 j =1
In parti ular, the nal aggregate amount LT an be represented as

2
Nt^T1 Mi (T2 ) NT1 i (T2 )

MX
X X X
LT = Lt +
2 Yi:j + Yi:j :
i=1 j =Mi (t)+1 i=Nt^T1 +1 j =1
For the rest of this se tion we work with the measure P onditioned
on Ft . Let
i (T2 )
MX
Si = Yi:j :
j =Mi (t)+1
For i Nt , given i , Si is then ompound Poisson distributed with

intensity parameter i (FD (T2 i ) FD (t i )). At time t, Nt is
known, so S1 + + SNt onditioned on 1 ; : : : ; Nt is again ompound
Poisson distributed with parameter (1 (FD (T2 1 ) FD (t 1 )) +
+ Nt (FD (T2 Nt ) FD (t Nt ))). The latter is known from risk
theory, see for instan e [10, p. 13℄ or [13, Thm 4.2.2℄.
For Nt < i NT , given i and i , Si is then ompound Pois-
1
son distributed with intensity parameter i (FD (T2 i )). We again
have that SNt +1 + + SNT onditioned on NT , Nt+1 ; : : : ; NT and
1
1
Nt +1 ; : : P
1
: ; NT , is ompound Poisson distributed with intensity pa-
1
rameter Ni=TNt +1 i (FD (T2 i )). So all in all we get that LT Lt =

1
2
S1 + + SNt + SNt +1 + + SNT given NT ; 1 ; : : : ; NT ; 1 ; : : : ; NT

1 1
1 1
is ompound Poisson distributed with intensity parameter

Nt NT1
X X
i (FD (T2 i ) FD (t i )) + i (FD (T2 i ))
i=1 i=Nt +1
Nt NT1
X X
=d i (FD (T2 i ) FD (t i )) + i (FD (T2 ~i )) (2.2)
i=1 i=Nt +1
where ~i are iid uniformly distributed on (t; T1 ) and independent of

Ft. Here =d means equality in distribution. Thus for t xed LT Lt 2
be omes a mixed ompound Poisson model.
3. Cal ulation of the CAT-future pri e

3.1. Deterministi i . In this se tion we will derive the future pri e
(1.2) when i = is deterministi .PWe therefore rst need the value
EP [expfL1 g℄. We remark that M j =1 Yij has a ompound Poisson
i
distribution with moment generating fun tion expf(mY (r) 1)g. This
yields
EP [expfL1 g℄ = expf(e(mY () 1) 1)g :
Let us onsider now the pro ess (Lt ) under the measure Q. For an
introdu tion to hange of measure methods we refer to [13℄. A simple
al ulation yields that under Q the pro ess (Lt ) is of the same type,
only with dierent parameters. (Nt ) is a Poisson pro ess with rate
h M1
nX oi
~ = EP exp Y 1j = expf(mY () 1)g :
j =1
The number of laims of the i-th atastrophe is Poisson distributed
with parameter ~ = (mY (R)) and the individual laims have the dis-
tribution fun tion F~Y (x) = 0x ey dFY (y )=mY (). The lags Dij have
the same distribution as under P .
The pri e of a CAT-future is therefore EQ [LT ^ 2℄. Denoting the
2
distribution fun tion of LT Lt under Q onditioned on Ft by F~L (; t)

2
we an express the pri e as
(Lt + EQ[(LT Lt ) ((LT Lt ) (2 Lt ))+ j Ft ℄)
2 2
Z 1
= Lt + EQ [(LT Lt ) j Ft ℄
2 (1 F~L (x; t)) dx :
2 Lt
But the problem with the above expression is that we have to nd the
n-fold onvolutions of FD [T2 ~℄, in order to al ulate the last term.
To nd an expli it expression seems to be hard.
Histori al data show that, so far, the ap 2 in the denition of the
CAT-future has not been rea hed. The largest loss ratio was hurri-
ane Andrew with L1 = 1:79. Under the measure P we have that
fLT > 2g is a rare event. Be ause we are dealing with atastro-
2
phe insuran e, the market risk aversion oeÆ ient annot be large.
Otherwise, atastrophe insuran e would not be possible. We therefore
assume that fLT > 2g is also a rare event with respe t to the mea-
2
sure Q, see also [9℄. The light tail approximation to our model then
assures that the tail of F~L (; t) is exponentially de reasing. That is
R 1 ~
2 Lt (1 FL (x; t)) dx will be small as long as Q(LT > 2) is small,
2
see also the dis ussion in Se tion 4. The latter depends of ourse on the
risk aversion oeÆ ient , whi h has to be small in order to be able to
negle t the last term. As in [9℄ we therefore propose the approximation
(Lt + EQ [(LT Lt ) j Ft ℄) to the pri e of the CAT-future, and we then
2
make the following denition.
Denition 3.1. Let pt be the pri e of the CAT-future at time t. The
upper bound papprox
t of pt dened as
Z 1
papprox
t = pt + (1 F~L (x; t)) dx
2 Lt
= (Lt + EQ [(LT Lt ) j Ft ℄) 2
is used as an approximation to the future pri e pt .

Theorem 3.2. Let the assumptions be as in Se tion 2 with a xed risk
aversion oeÆ ient . Assume further that i = is deterministi .
Then papprox
t for a given risk aversion oeÆ ient is given by
Nt
25 000 X
Lt + (FD (T2 i ) FD (t i ))
i=1

~ T1
+( t)EQ [FD (T2 ~ Q [Y ℄ :
~)℄ E
for t 2 [0; T1 ℄ and
NT1
25 000 X
~ Q [Y ℄

Lt + (FD (T2 i ) FD (t i ))E
i=1
for t 2 [T1 ; T2 ℄.
Proof: We only onsider EQ [LT Lt 2 j Ft℄. From the onsiderations
in Se tion 2 we know that for t < T1
EQ [(LT Lt ) j Ft ℄
2
Nt
hX i
= EQ ~ (FD (T2
i ) FD (t i )) Nt ; 1 ; : : : ; Nt

i=1
h XNT1 i
+ EQ ~ D (T2
F ~i ) EQ [Yij ℄
i=Nt +1
Nt
X
= (FD (T2 i ) FD (t i ))
i=1

~ T1
+( t)EQ [FD (T2 ~ Q[Y ℄ :
~)℄ E (3.3)
Note that
Z T2 t
1
EQ [FD (T2 ~)℄ = EP [FD (T2 ~)℄ = FD (s) ds ; (3.4)
T1 t T2 T1
provided t < T1 , and EQ [Y ℄ = m0Y ()=mY (). If T1 t T2 we nd

NT1
X
EQ [(LT 2
Lt ) j Ft ℄ = (FD (T2 ~ Q [Y ℄ :
i ) FD (t i ))E
i=1
The approximation error will be dis ussed in Se tion 4.
3.2. Sto hasti i . We now assume that the i 's are sto hasti and
independent. This an be seen as a measure of the severity of the
atastrophe. For simpli ity of the model, we assume that i an be
observed via reported laims only. Of ourse, in reality other informa-
tion as TV-pi tures or reports from the ae ted area will be available.
Then for laims o urring before t we have some information on the
intensity parameter i . We therefore have to work with the posterior
distribution of i given Ft . It would be desirable if the prior and the

posterior distribution would belong to the same lass, see the dis us-
sion in [6, Ch.10℄. We therefore hoose i to be distributed. Let
i ( ; ).
We nd

EP [expfL1g℄ = exp 1 :
mY () + 1
It again turns out that under the measure Q the pro ess (Lt ) is of the
same type with dierent parameters. (Nt ) is a Poisson pro ess with
rate ~ = ( mY () + 1) , i is ( ; mY () + 1) distributed,
Mi given i is onditionally Poisson distributedR with parameter ~ i =
i mY () and Y has distribution F~Y (x) = 0 ey dFY (y )=mY (). As
x
before the lags (Dij ) have the same distribution under Q as under P .
Thus Mi has a mixed Poisson distribution where the mixing variable
~ i is ( ; ( mY () + 1)=mY ()) distributed. Let ~ = and ~ =
( mY () + 1)=mY ().
We now x the time t at whi h we want to nd the CAT-future pri e.
For i Nt the posterior distribution of ~ i at time t is then
~ i jFt ( + Mi (t); FD (t i ) + ~) : (3.5)
Theorem 3.6. Let the assumptions be as in Se tion 2 with a xed risk
aversion oeÆ ient . Assume further that i ( ; ). Then papproxt
for a given risk aversion oeÆ ient , is given by
Nt
25 000 X
Lt + EQ [~ i j Ft ℄(FD (T2 i ) FD (t i ))
i=1
m ()( ~ T1 t)
+ Y EQ [FD (T2 ~)℄ EQ [Y ℄
mY () + 1
for t 2 [0; T1 ℄ and
NT1
25 000 X
Lt + EQ [~ i j Ft ℄(FD (T2 i ) FD (t i ))EQ[Y ℄
i=1
for t 2 [T1 ; T2 ℄.
Proof: For the al ulation of EQ [LT Lt j Ft ℄ we again split LT Lt
2 2
into the terms o uring from atastrophes o urred before and atas-
trophes that will o ur in the future. Consider rst the ase t < T1 .
The rst terms have expe tation
Nt
X
EQ [~ i j Ft ℄(FD (T2 i ) FD (t i ))EQ [Y ℄ :
i=1
Note that EQ [~ i j Ft ℄ = ( + Mi (t))=(FD (t i ) + ~).
For the expe tation of the se ond terms we obtain

~ T1 t)EQ [~ i FD (T2 ~)℄EQ [Yij ℄
(
~ T1 t)
mY ()(
= E [F (T ~)℄EQ[Y ℄ :
mY () + 1 Q D 2
The expe tation was already al ulated in (3.4). This yields the desired
expressions. If T1 t T2 we nd
NT1
X
EQ[(LT 2
Lt ) j Ft ℄ = EQ [~ i j Ft ℄(FD (T2 i ) FD (t i ))EQ [Y ℄ :
i=1
Note that with the ex eption of (3.4) the upper bound an be found
expli itly.
4. The approximation error

The results in Theorems 3.2 and 3.6 are both approximations, so it is
relevant to ask how good these approximations are. In this se tion we
will investigate this question. We only onsider the ase where i =
is onstant. For the mixed Poisson ase the results are similar.
4.1. The approximation of the approximation error. From Se -
tion 3.1 we know that the approximation error (AE) is given by the
following expression:
Z 1
(1 F~L (x; t)) dx (4.1)
2 Lt
where F~L (; t) denotes the distribution fun tion of LT Lt under Q
onditioned on Ft . The reason for omitting this term was that it is
2
hard to al ulate F~L (; t). In order to nd an approximation to the

expression above we will now try to use some of the approximations to
LT Lt known from a tuarial mathemati s. Namely the translated
2
gamma approximation and the Edgeworth approximation.
The idea behind the translated gamma approximation is to approx-
imate the distribution fun tion by k + Z where k is a onstant and Z
is (g; h) distributed, su h that the rst three moments of LT Lt 2
and k + Z oin ide. We already have al ulated the mean value L
of LT 2 Lt in (3.3). Standard al ulations yield also the ( ondi-
tional) varian e L2 and the ( onditional) oeÆ ient of skewness sL =
EQ [(LT Lt EQ [LT Lt ℄)3 j Ft ℄L 3 . From this the parameters of
2 2
the translated gamma distribution are found to be
4 2 2L
g= 2; h= ; k = L :
sL sL L sL
The approximation error therefore is approximated by

Z 1 Z 1 hg
AP(G) = y g 1e hy dy dx
2 Lt x k (g )
h g Z 1
= y g e hy dy
(g ) (2 Lt ) k
Z 1
(2 Lt k) y g 1 e hy dy :
(2 Lt ) k
The idea behind the Edgeworth approximation is to onsider the or-
responding standardized random variable Z and then to approximate
its distribution. So onsider the random variable
L L EQ [LT Lt ℄
Z= T p t 2
: 2
VarQ[LT Lt ℄ 2
The Taylor expansion of log MZ (r) around r = 0 has the form

r2 r3 r4
log MZ (r) = a0 + a1 r + a2 + a3 + a4 +
2 6 24
where

dk log MZ (r)
ak = :
dkr r=0
Simple al ulations show that a0 = 0, a1 = E [Z ℄ = 0, a2 = V ar[Z ℄ = 1,
a3 = sL and a4 = E [(LT Var[LtLTE [LLTt ℄ Lt ℄) ℄ 3 . In our ase a3 and a4 are
4
2 2
2
al ulated under Q and onditioned on Ft , and both the values an

2
be found by standard al ulations. We trun ate the Taylor series after

the term involving r4 . The moment generating fun tion of Z an be
written as

r3 r4 r6
MZ ( r ) e e
r = 2 a r = 6+ a r = 24 e r = 2 1 + a3 + a4 + a3 2 :
2 3 4 2
3 4
6 24 72
The inverse of expfr2 =2g is easily found to be the normal distribution
fun tion (x). For the other terms we derive
Z 1 Z 1
rner =2 = (erx )(n) 0 (x) dx =( 1)n erx (n+1) (x) dx :
2
1 1
Thus the inverse of rner =2 is ( 1)n times the n-th derivative of . The
2
approximation yields
P [LT
2
Lt x℄ = P [Z z ℄
a2
(z) a63 (3) (z) + 24
a4 (4)
(z ) + 3 (6) (z )
72
p
where z = (x E [LT Lt ℄)= Var[LT
2 2
Lt ℄. The approximation error
therefore is approximated by
p
AP(E) = Var[LT Lt ℄
2
Z 1
a3 (3) a a2
(z ) (z ) + 4 (4) (z ) + 3 (6) (z ) dz :
z
0
6 24 72
p
where z0 = ((2 Lt ) E [LT Lt ℄)= Var[LT Lt ℄.
2 2
We now have onstru ted two ways of approximating the AE. The
question is then whether we obtain a better pri e if we orre t the
un apped future pri e with these approximations, or we are better o
just using the un apped future pri e dire tly? We will now look at an
example in order to answer this question.
4.2. Example. The apped future pri e (FtC ) is al ulated a ording
to equation (1.2)
E [exp(L1 ) (LT ^ 2) j Ft ℄
FtC = P 2
EP [exp(L1 ) j Ft ℄
where a reliable value of the expression is obtained by Monte-Carlo
simulations. In order to use MC we make the following assumptions:
The laim sizes are exponentially distributed with parameter ,
The reporting lags are exponentially distributed with parameter
.
The un apped future pri e (FtU ) is al ulated a ording to Theorem 3.2.
We will keep all the parameters xed in the example, ex ept from the
premium and the risk aversion oeÆ ient in order to see how the
approximations depend on these two parameters. We use the following
parameters:
T1 = 1 T2 = 2 t = 0:5
=6 Nt = 3 = 0:0005
1 = 0:1 2 = 0:25 3 = 0:4
M1 (t) = 698 M2 (t) = 528 M3 (t) = 259
= (1 + )12 106 = 1000
Lt = E [Lt ℄ = 2:97 106 =3
is al ulated by the expe ted value prin iple with safety loading
under the assumption that all the laims will be reported.
The parameters are hosen su h that P (LT > 2) is onsistent with
2
the few data that we had. None out of the approximately 80 available
settlement values ex eeded the level 2. For dates before 1992 the ISO
index had to be estimated from the nal aggregate loss value (L1 ).
The largest values of the ratio LT = there have been seen so far is
2
1.7893 (the Eastern Loss Ratio from Hurri ane Andrew, Sept. 1992)
and 1.0508 (the Western Loss Ratio from Northridge Earthquake, 2nd
Mar h 1994). In our example with = 0:05 we have that P (LT = >
1:79) 0:01.
2
For dierent values of and , Table 4.1 shows the values of FtC ,
Ft , the approximation error AE = FtU FtC by using the un apped
U
future pri e, the approximation error AE(G) = (FtU AP(G)) FtC if
we orre t FtU by the gamma approximation to (4.1), and nally the
approximation error AE(E) = (FtU AP(E)) FtC if we orre t FtU by
the Edgeworth approximation (4.1).
FtC FtU AE AE(G) AE(E)

1 10 8 0.05 23666.8 23668.3 1.5 -1.9 0.5
1 10 8 0.10 22590.8 22592.5 1.7 0.2 1.4
1 10 8 0.15 21608.8 21610.2 1.4 0.7 1.3
1 10 7 0.05 25999.3 26009.7 10.4 -2.1 6.2
1 10 7 0.10 24822.5 24827.5 5.0 -1.0 3.2
1 10 7 0.15 23743.7 23748.0 4.3 1.5 3.6
2 10 7 0.05 29106.7 29158.8 52.1 0.7 32.0
2 10 7 0.10 27808.1 27833.4 25.3 -1.7 16.7
2 10 7 0.15 26605.0 26623.2 18.2 4.3 14.3
3 10 7 0.05 32817.4 33008.2 190.8 -6.0 62.4
3 10 7 0.10 31402.1 31507.9 105.8 -7.4 47.2
3 10 7 0.15 30052.8 30138.0 85.2 21.4 60.0
Table 4.1. The approximation errors.
From Table 4.1 we see, that for all the hosen parameters the un-
apped future pri e seems to approximate the apped future pri e fairly
well, and best when the risk aversion oeÆ ient is small or the safety
loading is large. But are the hosen parameters reasonable?
Let us rst dis uss the parameter. In insuran e the safety loading
is always positive, and looking at real data the safety loading seems to
be \large" when we are onsidering atastrophe insuran e. By \large"
we mean that the event fLT > 2g never has o ured.
2
The parameter is the risk aversion oeÆ ient for the single in-
suran e ompany when pri ing in a utility maximization framework
(see [9℄ for further details), or the markets risk aversion when pri ing
in a general equilibrium model (see [9℄ for further details). The rst
thing to note on the parameter is that the parameter is pri e de-
ned, i.e. it depends on the way we pri e the losses. Here the values of
the losses are \large" and therefore the parameter be omes \small".
The parameters are then hosen in su h a way that dierent pri es are
represented, for = 0:15 and = 1 10 8 the apped future pri e is
21608.8 and for = 0:05 and = 3 10 7 the apped future pri e is

32812.7. An indi ation that the single insuran e ompany or the mar-
ket should have a low risk aversion oeÆ ient, is the market onditions:
The CAT-future pays a high prot with a small probability and a low
prot with a high probability. After these remarks on the parameters
we now turn to the gures.
From Table 4.1 we see that there is some varian e on the gures from
the MC simulations. This is observed in the olumn named AE, where
the AE should be de reasing when the 's are in reasing. But apart
from this it is lear that both approximations give reasonable values for
the approximation error, i.e. if the un apped future pri e is orre ted
with one of the approximations we in general obtain a more a urate
pri e. From the values it seems like the AE(E) underestimates the AE,
but even though that it is the ase in this example this does not hold
in general. Based on this example the gamma approximation gives the
best approximations for nearly all the values. The only ex eption is for
= 1 10 8 , and = 0:05, but this is probably aused by the varian e
in the MC. So based on this example the gamma approximation is the
best one to use.
Finally we on lude that in our model under the above assumption
the un apped future pri e is a good approximation. But as mentioned
above we obtain a more a urate pri e if we orre t with one of the
approximations, and in this example the gamma approximation is the
best one to use.
5. Con lusion
This paper develops a model for insuran e future pri ing, whi h only
relies on the information available. The produ ts are pri ed solely from
observing the reporting stream. Contrary to the existing literature we
model the reporting times expli itly. We thereby obtain a more realisti
model.
The results of this arti le rely on an approximation to the exa t
future pri e. One therefore has to be areful applying the results
derived, be ause the results will be ina urate if the ap-probability
(P (LT > 2)) or the risk aversion oeÆ ient is \too large".
2
This paper suggest two ways to approximate the approximation er-
ror, the gamma approximation and the Edgeworth approximation. It
is shown that they both are useful in the determination of the error
level even though that the gamma approximation seems to be the best.
The results are derived spe ially for the CAT-futures, even though
an improved nan ial atastrophe insuran e produ t, the PCS-option,
was introdu ed in 1995. For a des ription of the PCS-option and an
explanation of why the CAT-future was improved see [5℄. The results
from this arti le annot dire tly be used for pri ing PCS-options be-
ause they have another stru ture. But, be ause of a strong orrelation
between laims reported and the PCS-index some of the ideas may be
used. This is a topi for further resear h.
A knowledgement
The authors thank a referee for his omments that lead to an im-
provement of the presentation.
Referen es
1. Aase, K.K. (1994): \An equilibrium model of atastrophe insuran e futures
ontra ts." Preprint.
2. Albre ht, P., A. Konig, and H.D. S hradin (1994): \Katastrophenversi-
ment von Versi herungsunternehmungen." Manuskript Nr. 2 Institut fur Ver-
3. Barfod, A.M. and D. Lando (1996): \On derivative ontra ts on atastrophe
losses." Preprint University of Copenhagen.
4. Buhlmann, H. (1980): \An e onomi premium prin iple." ASTIN Bulletin 11
(1), 52-60.
5. Christensen, C.V. (1997): \The PCS Option: an improvement of the CAT-
future." Manus ript, University of Aarhus.
6. Cox, D.R. and D.V. Hinkley (1974): \Theoreti al statisti s." Chapman and
Hall.
7. Cummins, J.D. and H. Geman (1993): \An Asian option approa h to the
valuation of insuran e futures ontra ts." Review Futures Markets 13, 517-557.
8. Embre hts, P., C. Kluppelberg and T. Mikos h (1997): \Modelling extremal
events for insuran e and nan e." Appli ations of Mathemati s 33, Springer-
Verlag, Berlin.
9. Embre hts, P. and S. Meister (1997): \Pri ing insuran e derivatives, the ase of
CAT-futures." In: Se uritization of Insuran e Risk: 1995 Bowles Symposium.
SOA Monograph M-FI97-1, p. 15-26.
10. Gerber, H.U. (1979): \An introdu tion to mathemati al risk theory." Huebner
Foundation Monographs, Philadelphia.
11. Gerber, H.U. and E.S.W. Shiu (1994): \Option pri ing by Ess her transforms."
Transa tions - So iety of A tuaries. 46, 99-191.
12. Kluppelberg, C. and T. Mikos h (1997): \Large deviations of heavy-tailed ran-
dom sums with appli ations in insuran e and nan e." Journal of Applied Prob-
ability 34, 293-308.
13. Rolski, T., H. S hmidli, V. S hmidt and J.L. Teugels (1999): \Sto hasti pro-
esses for insuran e and nan e." Wiley, Chi hester.
14. S hradin, H.R. and M. Timpel (1996): \Einsatz von Optionen auf den PCS-
S hadenindex in der Risikosteuerung von Versi herungsunternehmen." Mann-
heimer Manuskripte zu Versi herungsbetriebslehre, Finanzmanagement und
Risikotheorie, Nr. 72.
15. Sondermann, D. (1988): \Reinsuran e in arbitrage-free markets." Insuran e:
Mathemati s and E onomi s 10, 191-202.
(C. Vorm Christensen) Department of Theoreti al Statisti s and Op-

erations Resear h, University of Aarhus, Ny Munkegade 116, 8000
Aarhus C, Denmark
E-mail address : vormimf.au.dk
(H. S hmidli) Department of Theoreti al Statisti s and Operations
Resear h, University of Aarhus, Ny Munkegade 116, 8000 Aarhus C,
Denmark
E-mail address : s hmidliimf.au.dk
THE PCS-OPTION, AN IMPROVEMENT OF THE
CAT-FUTURE
Abstra t. In 1992, CBoT introdu ed the CAT-future as an alter-

native to atastrophe reinsuran e. But the produ t never be ame
very popular. In 1995 it was repla ed by a new produ t, the PCS-
option. This arti le des ribes the PCS-option and attempts to
explain why the new produ t is an improvement. The arti le also
explains how to hedge a atastrophe risk with PCS-options and
nally it ompares the PCS-options with traditional reinsuran e.
1. Introdu tion
The insuran e industry has been hit very hardly in the 1990s by
their atastrophe insuran es. This has been aused by a re ord num-
ber of natural atastrophe losses, of whi h the insuran e premiums only
overed a small part. At the same time many of the atastrophe pre-
miums are very large (approximately the value of the maximal losses),
so there is hardly no room for in reasing the apa ity in the insur-
an e market. Examples of risks whi h demand su h large premiums
are ooding in the Netherlands o uring every spring and earthquakes
i L.A. also o uring regularly. Thus the sear h for new apa ity has
led to the prospe t of trading insuran e risk not only within the tradi-
tional insuran e system but also transferring them to the more liquid
nan ial markets.
On the De ember 11, 1992 CBoT made the rst attempt to do so.
They laun hed futures on atastrophe loss indi es and related options
(CAT-future and options). The CAT-option, also referred to as the
future option, has as underlying instrument one atastrophe insuran e
future ontra t. Be ause of this relation the arti le will only onsider
the CAT-future in the se tion where these old produ t is under on-
sideration). Following initial diÆ ulties, whi h will be explained later,
these standardized ontra ts have been improved, and on September
29, 1995 CBoT introdu ed the PCS-options. The underlying assets
of the PCS-options are the PCS indi es. These loss indi es are pro-
vided daily to the CBoT by the Property Claim Servi es (PCS), whi h
is the re ognized industry authority for atastrophe property damage
estimates.
Date : April, 1998.
1
2 C. VORM CHRISTENSEN
This arti le will rst give a des ription of the PCS-option, then it will
des ribe the ISO index whi h was the underlying index of the CAT-
futures and also the main reason for the produ t's problems. Then
the index for the PCS-options is des ribed and it is explained how the
PCS-options improved the CAT-future. It will then be shown how to
hedge with PCS-options, and nally the arti le gives a des ription of
PCS-options versus reinsuran e.
2. Spe ifi ation of the PCS-option

In this se tion the denitions of the keywords that spe ify the PCS-
options are given. The information about the PCS-option is primarily
taken from [2℄ and [5℄, but some was also obtained by mailing with
people from the PCS a the CBOT. As mentioned above, the underlying
asset of the PCS-options are the PCS indi es. There are nine dierent
type of indi es, whi h are provided daily by the PCS. The nine indi es
are divided into one national index, ve regional indi es and three
state indi es. The ve regional indi es are: Eastern, Northeastern,
Southeastern, Midwestern and Western. The three state indi es are:
Florida, Texas and California. Ea h loss index tra ks PCS estimates for
insured industry losses resulting from atastrophi events (as identied
by PCS) in the area and loss period overed.
PCS-options an be traded as alls, puts, or spreads. Most of the
trading a tivity o urs in all spreads, sin e they essentially work like
aggregate ex ess-of-loss reinsuran e agreements, see Se tion 4. PCS-
options are traded both as \small ap" and as \large ap" ontra ts.
These aps limit the loss that an be in luded under ea h ontra t.
Small ap options tra k aggregate insured industry losses from $ 0 to
$ 20 billion. Large ap options tra k aggregate insured industry losses
from $ 20 billion to $ 50 billion.
The loss period is the time during whi h a atastrophi event must
o ur in order that resulting losses are in luded in a parti ular index.
During the loss period, PCS provides loss estimates as atastrophes
o ur. Most PCS options have quarterly loss periods, with ontra ts
listed for Mar h, June, September and De ember. Western and Cali-
fornia PCS-options have annual loss periods and are available only as
annual ontra ts. The last day of the loss period is the alendar day of
the quarter or year. Losses from atastrophes starting in one quarter
or year and ending in the next will be in luded in the quarter or year
in whi h the atastrophe started.
The development period is the time after the loss period during
whi h PCS ontinues to estimate and reestimate losses from atas-
trophes o ured during the loss period. PCS-option users an hoose
either a six-month or twelve-month development period. The develop-
ment period begins immediately after the loss period ends. The PCS
THE PCS-OPTION, AN IMPROVEMENT 3
index value at the end of the hosen development period will be used
for settlement purposes, even though PCS loss estimates may ontinue
to hange.
PCS-options settle in ash on the last business day of the develop-
ment period. The settlement value (LT ) for ea h index represents the
sum of then- urrent PCS insured loss estimates provided and revised
over the loss and development periods. PCS-options are options of Eu-
ropean type, that means that they an be exer ised on the expiration
day at the end of the development period only.
The value of the PCS- all option at expiration day T , exer ise pri e
X and ap value K an be expressed as
C (T; L(T )) = min(max(L(T ) X; 0); K X)
Due to diÆ ulties in trading options in industry loss dollar amounts,
the CBoT has developed a pri ing index to re e t dollar loss amounts
raging from $ 0 to $ 50 billion. Ea h PCS loss index represents the
sum of then- urrent PCS estimates for insured atastrophi losses in
the area and loss period overed, divided by $ 100 million and rounded
to the nearest rst de imal point. PCS-options pri es or premiums,
are quoted in points and tenths of a point. Ea h point equals $ 200;
ea h tenth of a point equals $ 20. We will end this subse tion with an
example.
Example 2.1. Let us onsider a reinsurer who buys a June Eastern
small ap all PCS-option with strike value of 20 and a development
period of six-months. This ontra t tra ks losses from atastrophi
events o uring in the Eastern region between April 1 and June 30
1997. The six-month development period runs from July 1 to De ember
31. The option will thus settle on De ember 31, 1997 a ording to the
settlement value of the index.
Apr May June July Aug Sep Oct Nov Dec
LOSS PERIOD DEVELOPMENT PERIOD SETTLEMENT

DAY
Figure 1. June PCS-option with development period

of six-months
Let us assume that the losses have been estimated to $ 3.565.270.000.

The index value would then be 35.65 rounded to 35.7. The value of the
all option is then
C (T; L(T )) = min(max(35:7 20; 0); 200 20) $200 = $3140
So in this example the reinsurer re eives $ 3140. If the loss index has
been estimated above $ 20 billion let us say $ 23 billion then the value
of the all option would be
C (T; L(T )) = min(max(230 20; 0); 200 20) $200 = $36000
and the reinsurer would then (only) have re eived $ 36000 be ause it
was a small ap option.
3. Loss estimation
As mentioned in the introdu tion, the PCS-options is an improve-
ment of the CAT-futures. The main problems with CAT-futures were
aused by the underlying asset, the so alled ISO index. The improve-
ments have therefore mainly been a hieved by hanging this underlying
asset. This subse tion will highlight some of the problems of the CAT-
futures, and explain how the introdu tion of the PCS-option solved
some of them. The information about the CAT-future is obtained
from [1℄ and [3℄. Let us rst onsider the ISO index.
3.1. The ISO index. Ea h quarter approximately 100 Ameri an in-
suran e ompanies reported property loss data to the ISO (Insuran e
Servi e OÆ e, a well known statisti al agent). ISO then sele ted a pool
of at least ten of these ompanies on basis of size, diversity of business,
and quality of reported data. The ISO index was then al ulated as
the loss ratio of this pool.
The ISO index:
ISO index = :
earned premiums
The list of ompanies in luded in the pool was announ ed by the
CBoT prior to the beginning of the trading period for that ontra t.
The CBoT also announ ed the premium volume of the ompanies par-
ti ipating in the pool prior to the start of the trading period. Thus
the premium in the pool was a known onstant throughout the trad-
ing period, and pri e hanges were attributed solely to hanges in the
markets expe tation of loss liabilities.
CAT-futures were traded on a quarterly y le, with ontra t months
Mar h, June, September, and De ember. A ontra t for any given
alendar quarter (the event quarter) was based on losses o uring in
the listed quarter, and beeing reported to the parti ipating ompanies
by the end of the following quarter. The six month period following the
start of the event quarter is known as the reporting period. The three
additional reporting months following the lose of the event quarter are
to allow for loss settlement lags that are ommon in insuran e. The
ontra ts expire on the fth day of the fourth month following the end
of the reporting period. The additional three months following the
reporting period is attributable to data pro essing lags. Trading was
ondu ted from the date the ontra t was listed until the settlement
date.
Example 3.1. The June ontra t overs losses from events o uring
in April, May and June as reported to the parti ipating ompanies by
the end of September. The June ontra t expires on January 5th the
following year. The ontra t is illustrated by the gure below.

EVENT QUARTER
REPORTING PERIOD
Figure 2. June CAT-future ontra t
Finally the settlement value for the CAT-futures was given by:
FT = $25000 min(IT ; 2)
where IT is the ISO index at time T, i.e. the ratio between the losses
in urred during the event quarter, though reported up un till three
months later, and the premium volume for the ompanies parti ipating
in the pool.
Let us now fo us on the problems with the ISO index. Let It be the
value of the ISO index at time t. One of the problems was that It was
only published on e before the settlement date. This took pla e just
after the end of the reporting period (the Interim report see gure 2).
This meant that the ompanies, parti ipating in the pool, had a possi-
bility of knowing at least part of the data used to form the index before
the settlement date, while it was ertainly more diÆ ult for other in-
surers. This reated a information asymmetry whi h was a potential
fa tor preventing people from entering the market of CAT-futures.
Another problem was the Moral Hazard problem. A ompany from
the pool ould manipulate data by delaying the report of a big loss so it
rst would be in luded in the next reporting period and thereby never
ae t the index. The ompanys intension for doing so, ould be that
the ompany had agreed to a short position of a future ontra t1 . That
this possibility existed, ould also have prevented people from entering
the market of CAT-futures.
1 When a ompany, at time t and at a pri e Ft , enters a short position of a future
ontra t, it means that the ompany should pay (FT Ft ) to the other part of the
ontra t at time T. The ompany will then like FT to be as small as possible
As mentioned in [4℄ a more serious problem ould o ur be ause the

reporting period was too short. If a late quarter atastrophe o urs
and laims are slow in developing, then the nal laims ratio for the
purpose of de iding the future payo ould be low relative to the a tual
nal laims ratio. This problem o urred in the Mar h 1994 ontra t
period, the period of the Northridge earthquake. The settlement ratio
was low and the ontra t payo did not truly re e t the a tual laim
loss. After this des ription of the ISO index and its problems, we now
turn to the PCS index.
3.2. The PCS index. Property Claim Servi es (PCS), a division of
Ameri an Insuran e Servi es Group, is the re ognized industry author-
ity for atastrophe property damage estimates. PCS is a not-for-prot
organization serving the insuran e industry.
When PCS, in its sole judgement, estimates that a natural or man-
made event within the United States is likely to ause more than $25
million in total insured property losses, and determines that su h ef-
fe t is likely to ae t a signi ant number of poli y holders and prop-
erty/ asualty insuran e ompanies, PCS identies the event as a atas-
trophe and assigns it a atastrophe serial number (a \PCS Identied
Catastrophe"). The types of insured "perils" that have aused insured
losses deemed atastrophi by PCS in lude, without limitation, tor-
nadoes, hurri anes, storms, oods, i e and snow, freezing, wind, water
damage, hail, earthquakes, res, explosions, vol ani eruptions and ivil
disorders. PCS ompiles three dierent types of estimates: The Flash
Loss Estimates, the Preliminary Loss Estimates and the Resurvey Loss
Estimates. Let us now fo us on these.
Simultaneously with announ ing that a atastrophe has been identi-
ed (generally within 48-72 hours after the o urren e of a PCS Iden-
tied Catastrophe), PCS generally provides a " ash" estimate anti -
ipated industry insured property losses from su h event. The Flash
Estimates generally are based on PCS's initial meteorologi al or seis-
mologi al information and/or initial telephoni information from indus-
try personnel and publi oÆ ials in the ae ted areas. Su h estimates
are expressed in terms of a range of estimated total insured property
losses. These Flash Loss Estimates give the insurers and reinsurers an
initial perspe tive on the atastrophe's severity, but are not in luded
in the indi es al ulated for the CBoT.
The indi es ompiled for the CBoT, omprise Preliminary Loss Es-
timates and are adjusted a ording to Resurvey Loss Estimates. The
Preliminary Loss Estimate of anti ipated insured property losses is
typi ally prepared and released within several days to two weeks after
o urren e of a PCS Identied Catastrophe. If a atastrophe is large
enough, PCS will ontinue to survey loss information to determine
whether its preliminary estimate should be adjusted. PCS generally
resurveys PCS Identied Catastrophes that, based upon its Prelimi-

nary Estimate, appear to have aused more than $250 million of insured
property damage. PCS usually releases the initial Resurvey Estimate
to subs ribers approximately 60 days after the Preliminary Estimate is
issued. PCS may ontinue the resurvey pro ess and publish additional
Resurvey Estimates approximately every 60 days after the previous
Preliminary Estimate or Resurvey Estimate, until it believes that the
industry insured property loss has been reasonably approximated. This
means that the insured losses due to ertain atastrophes may ontinue
to develop after PCS-option settlement. PCS ompiles its estimates of
insured property damage using a ombination of pro edures, in luding
a general survey of insurers, its National Risk Prole, and where ap-
propriate, its own on-the-ground survey. PCS will report the PCS loss
indi es on ea h CBoT trading day. But the indi es are only hanged
when a new Preliminary Loss Estimate is released or a Resurvey Loss
Estimate is released.
Let us now return to the problems of the CAT-futures and how the
PCS options solve them. Neither Ameri an Insuran e Servi es Group
nor any person employed by Ameri an Insuran e Servi es Group will
dis lose any estimate of total insured losses following a atastrophe to
any person prior to its oÆ ial publi ation. This means that all investors
re eive the same information at the same time. Thereby the problem
of asymmetri information is eliminated.
When PCS estimates the loss indi es, they ondu t surveys of the
market. These surveys are ondential and they are not used dire tly
in the estimation of the indi es. So it is extremely diÆ ult for insuran e
ompanies to ae t the indi es, and thereby the Moral Hazard Problem
is eliminated.
The onstru tion of the PCS-option also eliminates the problem by
late o ured atastrophes. The PCS index does not dire tly depend on
a number of reported laims and the time from the end of the event
period to the time the index is settled is also longer for the PCS-option
than it was for the CAT-future.
That these problems were solved, was probably the main reason for
the PCS-options higher trading a tivity ompared to the CAT-future.
But the fa t that the new produ t was more logi ally onstru ted than
the old one ould also have had an ee t. Hereby we mean that a
onstru tion using options instead of futures and \options on futures",
seems more logi al, when all the trading a tivities are in options.
Next will be explained, as mentioned in se tion 2, that the all
spreads work mu h like aggregate ex ess-of-loss reinsuran e agreements.
4. Hedging with PCS-options

This Subse tion will des ribe how to hedge against atastrophe losses
using PCS-option. Only the PCS-option spreads will be onsidered
sin e most of the trading a tivity o urs in these produ ts.
The buyers of PCS-options spreads are mainly large insuran e om-
panies and reinsuran e ompanies. The sellers ould be investors, as
for instan e ompanies earning money in relation to atastrophes (su h
as building supply rms or onstru tion ompanies). To illustrate how
PCS-option spreads work, lets now onsider a hypotheti al insuran e
ompany. The Safe-pla e Insuran e Company is a property/ asualty
insuran e ompany with a book of business heavily on entrated in the
Eastern region.
Assume that:
(a) Safe-Pla e Insuran e Company has a 0.2% market share (mea-
sured in written premium)
(b) Safe-Pla e's book is less exposed on average to hurri ane risk than
that of the industry. More spe i ally, assume that Safe-Pla e
anti ipates its losses to be 80% of the industry on average.
( ) Safe-Pla e wants to hedge atastrophe losses in the hurri ane sea-
son (the third quarter) by buying a layer of prote tion of $ 6
million in ex ess of $ 4 million.
The question is now, what kind of September Eastern option spreads
should Safe-Pla e buy (the September Eastern ontra t tra k third-
quarter losses for the eastern region of the United states)? Based on
the given assumption, Safe-Pla e al ulates the appropriate amount of
prote tion by relating its atta hment point to the industrys atta hment
points as follows:
1 1
Strike value = Comp. loss
omp. market share loss experien e
At the $4 million atta hment point:
1 1
Strike value = $ 4 million = $ 2.5 billion or 25 p.
0.2 % 80 %
At the $10 million atta hment point($ 6 million ex ess of $ 4 million):
1 1
Strike value = $ 10 million = $ 6.25 billion or 62.5 p.
0.2 % 80 %
Safe-Pla e's $ 6 million in ex ess of $ 4 million level of prote tion is
now approximated by a 25/65 all spread (PCS-option ontra t spe i-

ations all only for ve-point strike intervals). This translates to an
industry loss range of $ 2.5 billion to $ 6.5 billion.
Safe-Pla e al ulates the proper number of spreads as follows:
ammount of prote tion needed

Number of spreads =
amount of prote tion oered by ea h layer
$ 6 million
Number of spreads = = 750 spreads
$((65 25) $200)
They therefore de ides to buy 750 25/65 September Eastern all spreads
(the September Eastern ontra t tra k third-quarter losses for the east-
ern region of the United states). In other words they would buy 750
all at strike value 25 and simultaneously sell 750 all at strike value 65.
The value of a 25/65 all spread an be illustrated by gure 3. The two
dotted lines illustrate the payo from selling a all 65 and from buying
a all 25. The full-drawn line is the the total payo from buying a all
spread 25/65.
Call A (long position)
Option Spread A/B
Premium
of Call B
A B
PCS LOSS ESTIMATE
Premium
of Spread
Premium Call B (short position)

of Call A
Figure 3. A 25/65 all option spread.
If the losses have been estimated below $2.5 billion, the 25/65 all
spread has no value. If the losses have been estimated above $65 billion
Safe-Pla e re eives a full prote tion payment, that is, 40 $200 750,
or $6 million whi h is the amount of prote tion originally desired by the
rm. If the losses have been estimated between the 25/65 atta hment
points, Safe-Pla e is ompensated for the dieren e between the lower

atta hment point (25) and the a tual settlement value. For instan e,
assume that the losses have been estimated to $4 billion. This industry
loss amount orresponds to a $6.4 million aggregate loss for Safe-Pla e,
or a $2.4 million ex ess of the $4 million retained by the ompany. On
settlement day Safe-Pla e re eives ompensation equal to (40 25)
$200 750 spreads, or $2.25 million. This amount helps to oset the
ompanys original loss.
This example shows the PCS all spreads work mu h like layers of
aggregate ex ess-of-loss reinsuran e, but as we shall see in the next
se tion they are not perfe t substitutes.
5. PCS-options versus Reinsuran e ontra ts

As mentioned in se tion 4, the PCS-options are similar to the stru -
tures of typi al stop loss reinsuran e ontra ts, but there are important
dieren es between reinsuran e and nan ial ontra ts.
The buyers and sellers of a PCS-option are anonymous to ea h other
and the pri e is determined through an au tion market. For the rein-
suran e ontra t it is dierent, here the ontra t is negotiated between
the buyer and the seller, and the pri e is determined through a negoti-
ation pro ess. These onditions make the buyers of an a tively traded
PCS-options more assured of re eiving an arbitrage-free pri e than the
buyers of a reinsuran e ontra t. Even though the buyer negotiated
with several reinsurers before making a de ision.
A main problem of the PCS-option is that the loss, estimated by
the PCS, is not ne essarily perfe tly orrelated to the buyer's losses.
This is not a problem in reinsuran e be ause it is the buyer's own loss
experien es that are overed. But that the PCS-options are standard-
ized to all buyers and sellers does have some advantages. If the general
risk exposure suddenly hanges then the people on the option market
have the possibility of losing out a position by taking the opposite
position. The portfolio an also be adjusted using the experien e of
losses in luded in the index. For instan e if a ompany has an upper
layer, A say, and there had been already many atastrophes, so that
A is likely to be ex eeded, the ompany an adjust the portfolio by
buying AB -spreads for B > A, giving them a new upper layer B . This
is usually not possible for people on the reinsuran e market, be ause
of the buyer spe i reinsuran e ontra ts.
Another advantage of the PCS-options is the time fa tor. The PCS-
options an be bought and sold in a se ond, assuming the buyer has
been a epted by the learinghouse. Unlike the reinsuran e ontra t,
where it often takes quite a while before the ontra t is negotiated and
underwritten by the reinsurer. And in the reinsuran e market there
is no learinghouse to assure the buyers and sellers about the redit

worthiness of the other party.
PCS-options and reinsuran e an both be used in hedging under-
written risk, but as seen above they are not perfe t substitutes. It is
therefore likely that we will see both type of ontra ts in the future.
Referen es
[1℄ Albre ht, P. and Konig, A. and S hradin H.D. (1994): "Katastrophenversi-
ment von Versi herungsunternehmungen" Manuskript Nr. 2 Institut fur Ver-
[2℄ The Chi ago Board of Trade (1995): \A User's Guide, PCS options".
[3℄ Embre hts, P. and Meister, S. (1995): \Pri ing insuran e derivatives, the ase
of CAT-futures" Paper presented at the Symposium on Se uritization of Insur-
an e Risk, Atlanta, Georgia, May 25-26 1995.
[4℄ O'Brien, T (1997):\Hedging strategies using atastrophe insuran e options"
Insuran e: Mathemati s and E onomi s 21 (1997) 153-162
[5℄ S hradin, H. R. und Timpel, M. (1996): \Einsatz von Optionen auf den
PCS-s hadenindex in der Risikosteuerung von Versi herungsunternehmen"
Aarhus C, Denmark
A NEW MODEL FOR PRICING CATASTROPHE
INSURANCE DERIVATIVES
Abstra t. We want to pri e atastrophe insuran e derivatives

and we are therefore fa ing two main problems. The rst prob-
lem is that under a realisti model for the underlying loss pro ess
the market is in omplete and there exist many equivalent mar-
tingale measures. Hen e there are several arbitrage free pri es of
the produ t. The other problem is that we prefer a heavy tail for
the underlying loss index, but heavy tails often give omputational
problems. In this note we will present a model whi h in some sense
takes are of both the problems. We will in parti ular onsider the
PCS option, but the approa h an also be used for pri ing other
se urities relying on a atastrophe loss index.
1. Introdu tion
After Hurri ane Andrew in 1992 there followed a reinsuran e apa -
ity shortage and a huge in rease in property atastrophe reinsuran e
premiums. Both phenomena where reinfor ed by the o urren e of the
Northridge Earthquake in 1994. The reinsuran e industry therefore
needed new apital. This apital should be found in the nan ial mar-
ket and the way to obtain it was to reate the se uritization market.
One of the rst produ ts on this market was the CAT future in-
trodu ed by the CBOT (Chi ago Board of Trade) in 1992. And ever
sin e the market has tried to full the investors requirements, but the
market is still not well laun hed. J. A. Tilley [12℄ is mentioning the
following four reasons why this market is emerging so slowly. First,
sin e 1994 there has been a generally favourable atastrophe loss ex-
perien e and as a result of this the reinsuran e pri es have de reased.
This be omes a problem be ause many edents of risk both primary
writers and reinsurers have onsidered se uritization as an alternative
to reinsuran e rather than omplementary to reinsuran e. Se ond, in-
surers are unwilling to be pioneers, be ause of the high development
ost. Third, the fa t that the produ ts are un orrelated to other nan-
ial produ ts is not a good enough selling story for investors. Investors
Date : July 1, 2000.
Key words and phrases. Catastrophe Insuran e Derivatives; Derivative pri ing;
Claims-pro ess; Heavy tails; Change of measure.
1
want to understand the nature of the risk, and this takes time. And
nally there still remains unanswered questions about what form and
stru ture of insuran e linked se urities and derivatives will be viewed
most favourable by investors.
But even though the market have not been well laun hed and the
produ ts has not been standardized, a ademi s has tried to model the
pri es of su h produ ts see [1℄, [2℄, [5℄, [6℄ and [8℄. And this is also the
aim of this paper. We aim to nd a model that solves two of the main
problems related to pri ing. The rst problem is that if we hoose a
realisti model for the underlying loss pro ess the market will be in-
omplete and there will exist many equivalent martingale measures.
Hen e there exists a large set of arbitrage free pri es of the produ t.
The next problem is that we like a heavy tail for the underlying loss
index, but heavy tails often give omputational problems. The model
presented takes in some sense are of both these problems and is to our
knowledge the rst one to do so. To derive the pri e of the se urities
we use results from Gerber and Shiu [10℄. In [10℄ it is shown that the
Ess her transform is an unique and transparent te hnique for valuing
derivative se urities if the logarithms of the underlying pro ess are gov-
erned by a ertain sto hasti pro ess with stationary and independent
in rements (a Levy pro ess). We propose here su h a model and by way
of example we al ulate pri es for one the most standardized produ ts
on the market namely the PCS option.
In the remaining part of this introdu tion we give a short des ription
of the PCS option, and the keywords that spe ify the PCS option are
given. In Se tion 2 we present the model of the underlying loss index
for the PCS option, and show how the option pri e is determined within
this model. In Se tion 3, we show how the results from [10℄ an be used
in our ontext to nd the risk neutral Ess her measure. In Se tion 4
we show how to ompute the risk neutral Ess her measure for the loss
period and the development period. In Se tion 5 we then al ulate the
pri e for the PCS option based on the results obtained in the previous
se tions. And nally there are some on luding remarks.
1.1. Spe i ation of the PCS option. In this se tion the denitions
of the keywords that spe ify the PCS options are given. For a more
detailed des ription of the PCS option see [3℄ or [4℄.
The PCS options are traded by Chi ago Board of Trade and are
regional ontra ts whose value is tied to the so alled PCS Index. The
PCS index tra ks PCS estimates for insured industry losses resulting
from atastrophi events (as identied by PCS) in the area and loss
period overed. The options are traded as apped ontra ts, i.e. the ap
limit the amount of losses that an be in luded under ea h ontra t.The
value of a PCS all option at expiration day T , with exer ise pri e A
A NEW MODEL FOR PRICING CAT INS DERIVATIVES 3
and ap value K is given by

C (T; LT ) = min(max(LT A; 0); K A)
where LT is the value of the PCS index at time T .
PCS options an be traded as European alls, puts, or spreads. Most
of the trading a tivity o urs in all spreads, sin e they essentially work
like aggregate ex ess-of-loss reinsuran e agreements see [4℄ for further
explanations.
The option ontra t in ludes both a loss period and a development
period. The loss period is the time during whi h a atastrophi event
must o ur in order for resulting losses to be in luded in a parti ular
index. During the loss period, PCS provides loss estimates as atas-
trophes o ur. The development period is the time after the loss
period during whi h PCS ontinues to estimate and reestimate losses
from atastrophes o urred during the loss period. The reestimations
may result (and have resulted histori ally) in adjustments upwards and
downwards. PCS option users an hoose either a six-month or twelve-
month development period. The settlement value for ea h index repre-
sents the sum of then- urrent PCS insured loss estimates provided and
revised over the loss and development periods.
2. The underlying model

The most natural way to model the underlying loss index is to model
it by a marked point pro ess with a heavy tailed distribution fun tion
for the marks. But as previous papers has shown it is hard to pri e
derivative se urities in su h a model see [1℄, [2℄, [5℄ and [8℄. The idea
in this paper is therefore to sear h for another model than the marked
point pro ess. This model may not be perfe t, but on the other hand
we hope to nd a model that has a heavy tail, allows for u tuation
and gives the possibility to express the pri e in a losed form.
The model we present below is inspired by Gerber and Shiu [10℄. In
[10℄ they show how one an obtain a risk neutral measure in an unique
and transparent way if the logarithms of the value of the underlying
se urity is a Levy pro ess. The idea is now to hoose su h a model.
Let now Lt be the underlying loss index for a atastrophe insuran e
derivative, [0; T1 ℄ be the loss period and [T1 ; T2 ℄ be the development
period. We then assume that Lt for all t 2 [0; T2 ℄ is des ribed by
Lt = L0 exp(Xt )
where Xt is a levy pro ess in the development period and in the loss
period and L0 2 IR+ . We model Xt dierently in the loss period and
the development period, for a similar model see [11℄. The question
is then how to model Xt for the loss period and for the development
period.
For t 2 [0; T1 ℄ we will model Xt by a ompound Poisson pro ess

Nt
X
Xt = Yi 8t 2 [0; T1℄
i=1
where Nt is a Poisson pro ess with a xed parameter 1 , and Yi is
exponentially distributed with parameter . We hereby obtain one of
the desired properties namely as mentioned above the heavy tail for Lt ,
e.g. when Xt Exp() then Lt L0 is Pa(; L0 ) distributed. But as
mentioned above this model is not hosen be ause it is the most obvious
one but be ause it has a heavy tail, allows for u tuation and gives the
possibility to express the pri e in a losed form. The model therefore
also has some disadvantages ompared to a more natural model, rstly
late atastrophes be ome more severe than earlier ones and se ondly
L0 = L0 > 0. For this reason this model should only be used as a rst
\ rude" approximation to the real world. We have tried to work out
these problems, but this seems to be hard.
It should be mentioned that it is possible to make a model whi h
allows for more u tuation,
PM i
e.g. we an also express the pri e in a losed
form with Yi = j =1 Yij where Mi is negative binomial distributed and
Yij is exponentially distributed, but to keep the model tra table we
onsider the simple model. Also in order to keep the model simple we
assume that all the adjustments are done in the development period.
We now have to hoose a model for Xt for the development period.
We know that the adjustments are done both upwards and downwards
we will therefore again des ribe Xt as a ompound Poisson pro ess for
t 2 [T1 ; T2 ℄
N~t T1
X
Xt = XT + 1
Y~i
i=1
where N~t is a Poisson pro ess with a xed parameter 2 and Y~i is
normally distributed (N(; )), where the most natural hoi e of
is = 0 (unbiased previous estimates). In order to use the results
from Gerber and Shiu [10℄ we need to assume that the pro ess Xt for
t 2 [0; T1 ℄ is independent of the pro ess Xt XT for t 2 [T1 ; T2 ℄. In
1
the real world one will expe t some dependen e but the assumption is
invariable in order to use the results form [10℄.
The value of the PCS all option at expiration day T2 , with exer ise
pri e A and ap value K is given by
C (T2 ; LT ) = min(max(LT
2 2
A; 0); K A):
Let Ft be the information available at time t. We will then make the
following assumption
Ft is the smallest right ontinuous omplete ltration, su h that

the aggregate amount of reported losses at time t (Lt ) is (Ft )-
adapted.
The value of the option at time t is then
C (t; Lt ) = exp( r(T2 t))E [C (T2 ; LT )jFt ℄
2
where r is the risk free interest rate and E is the mean value a ording
to a risk neutral measure. Before we an pro eed further in the al u-
lation of the option pri e we will have to hoose a risk neutral measure.
This is done in the next se tions.
3. The omputation of the risk neutral measure

This se tion des ribe how to ompute a risk neutral measure using
the Ess her Transform. The theory was introdu ed by Gerber and
Shiu [10℄. But some adjustments have to be made in order to use their
results in our ontext.
3.1. The omputation of the risk neutral measure. Let Lt be
the value of the PCS index at time t.
Lt = L0 exp(Xt ); 8t 2 [0; T1℄; (3.1)
where Xt is a Levy pro ess. To keep it simple we only onsider the
loss period, we extend the results to the development period later. Let
M (z; t) be the moment generating fun tion dened by:
Z 1
M (z; t) := E [exp(zXt )℄ = exp(zx)F (dx; t) (3.2)
1
provided the integral is nite, where F denotes the distribution fun tion
for Xt . Be ause of the independent stationary in rements we then have,
(see [9℄, se tion IX.5), that
M (z; t) = (M (z; 1))t (3.3)
For any h 2 IR the Ess her-Transformation F (dx; t; h) is dened as:
exp(hx)F (dx; t)
F (dx; t; h) = : (3.4)
M (h; t)
From this transformed density we dene the Ess her-transformed mo-
ment generating fun tion as:
Z 1
M (z + h; t)
M (z; t; h) = exp(zx)F (dx; t; h) = : (3.5)
1 M (h; t)
Then it follows from (3.3) and (3.5) that
M (z; t; h) = (M (z; 1; h))t (3.6)
The idea of Gerber and Shiu [10℄ is to hoose h = h su h that

the dis ounted underlying pro ess here fe rt Lt g be omes a martin-
gale under the Ess her transformed measure. But absen e of arbitrage
arguments do not apply be ause the underlying pro ess Lt is a loss
index and not a pri e pro ess, i.e. it gives no meaning to derive the
risk neutral measure under the onditions that fe rt Lt g should be a
martingale. So we have to onsider another pro ess. Let Pt be the
deterministi premium paid till time t to re eive the value Lt at time
t and assume that the index fLt =Pt g is a traded asset. We then use
the idea of Gerber and Shiu by hoosing h = h su h that the pro ess
fe rtLt =Pt g is a martingale under the Ess her transformed measure.
The question now is how to model Pt . We have to onsider the loss
period and the development period separately. We therefore rst on-
sider the loss period. Insuran e markets are ompetitive and ertainly
with the introdu tion of se uritization whi h oer an alternative to
reinsuran e, we argue that it is reasonable to assume that the insuran e
markets reates no arbitrage possibilities. We will therefore al ulate
the premium a ording to the adjusted parameter prin iple suggested
by Venter [13℄. See the latter paper for a des ription of the premium
prin iple and a dis ussion of why this premium prin iple is arbitrage
free. Let now ~1 and ~ be the adjusted parameters and let X~t be the
adjusted pro ess, i.e. X~ t is a ompound Poisson pro ess with Poisson
parameter ~1 and with marks that are exponentially distributed with
parameter ~ . . The premium is then:
Pt = EP [L~ t ℄
= EP [L0 exp(X~ t )℄
~ t
= L0 exp( 1 )
(~ 1)
Motivated by this we will use the following model for Pt

Pt = L0 exp(1 t)
We are now ready to nd the parameter hl and thereby derive the
risk neutral measure in the loss period. hl is hosen su h that the pro-
ess fe rt Lt =Pt g is a martingale under the Ess her transformed measure
) exp((r + 1 )t) = E [exp(Xt )℄
Z 1
) exp((r + 1 )t) = exp(x)F (dx; t; hl )
1
) exp((r + 1 )t) = M (1; t; hl ) (3.7)
By (3.6) it follows that the ondition for hl in the loss period is:
exp(r + 1 ) = M (1; 1; hl ) (3.8)
For the development period the situation is similar, the model for
Xt is just dierent. Let now ~2 , ~ and ~ be the adjusted parameters
orresponding to the development period. For t 2 [T1 ; T2 ℄ the premium
is:
Pt = EP [L0 exp(X~ t )℄
= EP [L0 exp(X~ T ) exp(X~ t X~ T )℄
1 1
= L0 exp(1 T1 ) exp(~2 (t T1 )(e +~ 1))

~2
2
= L0 exp(1 T1 ) exp(2 (t T1 )):

And as before it follows that the ondition for hd in the development
period is given by:

) e(r+ )T e(r+ )(t T ) = E [exp(XT ) exp(Xt XT )℄
1 1 2 1
1 1
) e(r+ )T e(r+ )(t T ) = Ml (1; T1; hl )Md (1; t T1 ; hd)

1 1 2 1
where Ml (1; t; h) and Md (1; t; h) denotes the Ess her-transformed mo-

ment generating fun tion for Xt for t in the loss period and development
period respe tively. It hereby follows that the ondition for hd in the
development period is:
exp(r + 2 ) = M (1; 1; hd ) (3.9)
The Radon-Nikodym derivative for the risk neutral Ess her measure
on the -algebra Ft an now be hara terized
8
dQ < ehl X t
Ml (hl ;t) t 2 [0; T1 ℄
jF =
dP t h X h (X X )
: e l T1 e d t T1
Ml (hl ;T1 ) Md (hd ;t T1 ) t 2 [T1 ; T2 ℄
where hl and hd are given by equation 3.8 and equation 3.9 respe tively.
Above we derive the risk neutral measure Q under the assumption
that fLt =Pt g is a traded index, but it should be mentioned that this
assumption is not stri tly needed. It is basi ally the information in Pt
that determines the Q measure, i.e. the measure Q is derived su h that
it evaluates the risk in the same way as Pt does. So instead of using
that fLt =Pt g is a traded index,Pthe measure Q an be derived dire tly
from the equation e rt EQ [exp( Ni=1t Xi )℄ = exp(1 t).
Although there is more than one equivalent measure, the risk neutral
Ess her measure provides a unique and transparent answer. Motivated
by [10℄ we now try to justify the hoi e of the Ess her measure by
looking at a representative investor maximizing his expe ted utility.
3.2. The representative investor with power utility fun tion.

Consider a market with only the traded index (Lt =Pt ) and a risk free
bond and their derivative se urities. To keep it simple we only onsider
the loss period. Assume there exists a representative investor who has
m shares of of the traded index Lt =Pt and who bases his de isions on
a risk-averse utility fun tion u(x). Consider then a derivative se urity
that provides a payment t at time t, t > 0; t is a fun tion of the
index pro ess (Lt =Pt ) until time t. What is the investors pri e for the
derivative se urity, su h that it is optimal for him not to buy or sell
any multiple of it? Let V0 denote this pri e. Mathemati ally, this leads
to the fun tion
( ) = E [u(mLt =Pt + (t ert V0 ))℄
is maximal for = 0. From
0 (0) = 0
we obtain
0
V0 = e rt E [t u (mLt =Pt )℄
E [u0 (mLt =Pt )℄
(as a ne essary and suÆ ient ondition, sin e 00 ( ) < 0 if u00 (x) < 0).
In the parti ular ase of a power utility fun tion with parameter > 0,
x1
if 6= 1

u(x) = 1
ln(x) if = 1
We have u0 (x) = x , and
E [ (m(Lt =Pt )) ℄
rt E [t (Lt =Pt ) ℄
V0 = e rt t = e (3.10)
E [(m(Lt =Pt )) ℄ E [(Lt =Pt ) ℄
Formula (3.10) must hold for all derivative se urities. For t = Lt =Pt
and therefore V0 = 1, (3.10) be omes
rt E [(Lt =Pt )1 ℄
1=e
E [(Lt =Pt ) ℄
or
M (1 ; t)
exp((r + 1 )t) = : (3.11)
M ( ; t)
Comparing (3.11) with (3.7) we see that the value of the parameter
is hl . Hen e Pt is indeed the expe tation of the losses Lt al ulated
with respe t to the risk neutral measure.
The results from this se tion will now be used in the next se tion,
where the on rete risk neutral Ess her measures for both the loss
period and the development period will be omputed.
4. The risk neutral Ess her measures

In this se tion we ompute the risk neutral Ess her measures for both
the loss period and the development period.
4.1. The risk neutral Ess her measure for the loss period.
In this se tion we will ompute the risk neutral Ess her measure for
the ompound Poisson pro ess where the marks are exponentially dis-
tributed.
Nt
X
Xt = Yi
i=1
where Nt Po(1 t) and Yi Exp().
The moment generating fun tion of Xt is
Nt
X
M (z; t) = E [exp(z ( Yi ))℄
i=1

= exp 1 t 1 : (4.1)
z
The Ess her-transformed moment generating fun tion is then om-
puted a ording to (3.5)

M (z; t; h) = exp 1 t
(z + h) h

( h)
= exp 1 t 1 : (4.2)
h ( h) z
From (4.1) and (4.2) it follows that the Ess her transformed pro ess
is again a pro ess of the same type as the original one, provided h < .
Let X~t denote the Ess her transformed pro ess, then
N~t
X
X~t = Y~i
i=1
where we now have that N~t Po(1 h t) and Y~i Exp( h).
We are now ready to al ulate the parameter hl whi h determines
the risk neutral Ess her measure.
We use (3.8) to nd hl
M (1; 1; hl ) = exp(r + 1 )

( hl )
) exp 1 h ( ( h ) 1 1) = exp(r + 1)
l l
) (hl )2 (2 1)hl + ( 1 + r +1 ) = 0 (4.3)
1
(4.3) is a se ond order equation where only one of the solutions fullls
the restri tion hl < .
Finally we will ompute P (Xt x)

P (Xt x) = P (X~ t x)
1
X n
X
= P (Nt = n)P ( Y~i x)
n=0 i=0
X1 Z x
= P (Nt = n) ( hl )n (n) 1 z n 1 e ( hl )z dz
n=0 0
1 n
1 t (1 t)
X
= e (n; ; x) (4.4)
n=0
n!
R hl )z dz
where 1 = 1 hl and (n; ; x) = 0x ( hl )n (n) 1 z n 1 e (
4.2. The risk neutral Ess her measure for the development pe-
riod. In this se tion we will ompute the risk neutral Ess her measure
for the ompound Poisson pro ess where the laim sizes are normally
distributed.
Nt
X
Xt = Yi
i=1
where Nt Po(2 t), and Yi N (; ).
The moment generating fun tion of Xt is
Nt
X
M (z; t) = E [exp(z ( Yi))℄
i=1
2
= exp 2 t e 2
z 2 +z 1
(4.5)
The Ess her-transformed moment generating fun tion is then om-
puted a ording to (3.5).
2 (z +h)2 +(z +h) 2 h2 +h

M (z; t; h) = exp 2 t e 2 e 2

= exp 2 te h +h e z +(+ h)z 1
2 2
(4.6)
2 2 2
2 2
From (4.5) and (4.6) it follows that the Ess her transformed pro ess
is again a pro ess of the same type as the original one. Let X~t denote
the Ess her transformed pro ess then.
N~t
X
X~t = Y~i
i=1
where we now have N~t Po(2 e t) and Y~i N ( 2 h + ; 2).
2 h2 +h
2
We are now ready to al ulate the parameter hd whi h determines

the risk neutral Ess her measure.
We use (3.9) to nd hd

M (1; 1; h ) = exp(r + 2 )

) exp 21 e (1+hd ) +(1+hd ) e hd +hd
2 2
= exp(r + 2 )
2 2
2 2
) e (1+hd) +(1+hd ) e hd +hd = r + 2

2 2
(4.7)
2 2
2 2
2
the solution to (4.7) has to be found numeri ally.
Finally we will ompute P (Xt x)
P (Xt x)
= P (X~ t x)
1 n
h +h (2 te hd +hd )n
2
X X 2
P ( Y~i x)
2 2
= exp( 2 te d d )
2
2
n=0
n! i=1
1 2 h 2 +h
X 2 h 2 +h (2 te d d )n x n( 2 hd + )
= exp( 2 te 2 d d )
2
n!
( p 2 )
n=0 n
1
X ( t)n x n
= exp( 2 t) 2 ( p 2 ) (4.8)
n=0
n! n
where 2 = 2 te hd +hd and = 2 hd + . For later use we also
2 2
2
dene 2+1 = 2 te (hd +1) +(hd +1) and +1 = 2 (hd + 1) + .

2
2
2
5. Cal ulation of the PCS option pri e

Now we have al ulated the risk neutral Ess her measure for both
the loss period and the development period. We are therefore ready to
al ulate the PCS option pri e.
Let us now onsider the PCS all option with exer ise pri e A, ap
K and expiring date T2 . Let v1 (t) := ln(A=(L0 exp Xt )) and v2 (t) =
ln(K=(L0 exp Xt )). The value of the option at time t 2 [T1 ; T2 ℄ is:
C (t; Lt )
= E [exp( r(T2 t)) min(max(LT A; 0); K A)jFt ℄ 2
= E [exp( r(T2 t) min(max(L0 exp(Xt ) exp(XT Xt ) A; 0); K 2

A)jFt ℄
Z v2 (t)
= exp( r(T2 t)) (Lt exp(x) A)F (dx; T2 t; hd )
v1 (t)

+(K A)(1 F (v2 (t); T2 t; h ))
d
Z v2 (t)
= exp( r(T2 t)) Lt exp(x)F (dx; T2 t; hd )
v1 (t)

+K (1 F (v2 (t); T2 t; hd )) A(1 F (v1 (t); T2 t; hd )) :
Using (3.4), (3.5) and (3.7) the integrand an be redu ed further:

exp((hd + 1)x)F (dx; T2 t)
exp(x)F (dx; T2 t; hd ) =
M (hd ; T2 t)
M (hd + 1; T2 t)
= F (dx; T2 t; hd + 1)
M (hd ; T2 t)
= M (1; T2 t; hd )F (dx; T2 t; hd + 1)
= exp(2 (T2 t))F (dx; T2 t; hd + 1)
We hereby obtain:

C (t; Lt ) = exp( r(T2 t)) Lt exp(2 (T2 t)) F (v2 (t); T2 t; hd + 1)

F (v1 (t); T2 t; hd + 1) + K (1 F (v2 (t); T2 t; hd ))

A(1 F (v1 (t); T2 t; hd )) (5.1)
And if we use the results from the Se tion 4.2 we obtain
C (t; Lt )
1
X (+1 (T2 t))n
= e( 2 r)(T2 t) L
t exp( 2+1 (T2
t)) 2
n=0
n!

v2 (t) n+1 v1 (t) n+1
( p ) ( p 2 )
n 2 n
1
X ( (T t))n
+e r(T t) exp( 2 (T2 t)) 2 2
2
n=0
n!
v (t) n
K (1 ( 2 p 2 ))
n
v (t) n
A(1 ( 1 p 2 )) (5.2)
n
If t 2 [0; T1 ℄ the value of the all option at time t is given by
C (t; Lt ) = e r(T t) E [C (T2 ; LT )jFt ℄
2
2
= e r(T t) E [E [C (T2 ; LT )jFT ℄jFt ℄

2
2 1
the value of E [C (T2 ; LT )jFT ℄ is known from (5.2). At time t < T1

2 1
the values of LT ; v1 (T1 ) and v2 (T1 ) are sto hasti . The onditional
1
mean value at time t is therefore obtained by integrating the expression
with respe t to the distribution fun tion for the risk neutral Ess her
transformed pro ess in the loss period whi h we al ulated in se tion
4.1.
The values of LT , v1 (T1 ) and v2 (T1 ) an all be expressed by the value
1
of an independent opy (X~ t ) of Xt .

LT = L0 exp(Xt) exp(XT Xt ) =d L(t) exp X~(T

1 1 1 t)
v1 (T1) = v1 (t) XT + Xt =d v1 (t) X~(T t)
1 1
v2 (T1) = v2 (t) XT + Xt =d v2 (t) X~(T t)

1 1
Let now F~ (dx; T1 t; hl ) denote the Ess her transformed distribution
for X~ (T t) , whi h we found in se tion 4.1 (hl denote the parameter
1
whi h determines the risk neutral Ess her measure in the loss period).
The value of the option pri e at time t 2 [0; T1 ℄ is then
C (t; Lt ) = e( 2 r)(T1 t) L0 exp(X )
t
Z 1 1
X (+1 (T2 T1 ))n
exp(x) exp( 2+1 (T2
T1 )) 2
1 n=0
n!
v (t) x n( 2 (h + 1) + )
( 2 p 2d )
n
v1 (t) x n( 2 (hd + 1) + ) ~
( p 2 ) F (dx; (T1 t); hl )
n
Z 1X 1
( (T T1 ))n
+e r(T t) 2
exp( 2 (T2 T1 )) 2 2
1 n=0 n!
v (t) x n
K (1 ( 2 p 2 ))
n
v1 (t) x n ~
A(1 ( p 2 )) F (dx; (T1 t); hl )
n
(5.3)
where F~ (dx; (T1 t); hl ) is given by (4.4)
F~ (dx; (T1 t); hl )
1
X ( (T t))n
= exp( 1 (T1 t)) 1 1 (n; ; x)
n=0
n!
From the above results we an now state the following theorem.

Theorem 5.4. Let Lt be the value of the PCS index at time t;
Lt = L0 exp(Xt ) 8t 0
For t 2 [0; T1 ℄ (the loss period) assume that
Nt
X
Xt = Yi
i=1
where Nt Po(1 t) and Yi Exp().
For t 2 [T1 ; T2 ℄ (the development period) assume that

N~t T1
X
Xt = XT + 1
Y~i
i=1
where N~t Po(2 t), and Yi N (; ).
Then the pri e of the PCS all option for t 2 [T1 ; T2 ℄ is given by (5.2)
and for t 2 [0; T1 ℄ it is given by (5.3).
6. Con lusion
The purpose of this note was to derive a model for pri ing insur-
an e derivatives whi h allows for heavy tails and also provide a unique
pri ing measure. We su eeded in nding su h a model by modelling
the logarithms of the loss pro ess as a ompound Poisson pro ess with
exponential distributed marks in the loss period and with normal dis-
tributed marks in the development period. The pri e was then found by
evaluating the future payout of the insuran e derivative under the risk
neutral measure derived by the Ess her approa h. We then al ulated
the exa t pri e in the ase of the PCS option.
Referen es
1. Aase, K.K. (1994): \An equilibrium model of atastrophe insuran e futures
ontra ts." Preprint University of Bergen.
2. Barfod, A.M. and D. Lando (1996): \On Derivative Contra ts on Catastrophe
Losses." Preprint University of Copenhagen
3. Chi ago Board of Trade (1995): \A User's Guide, PCS options."
4. Christensen, C.V. (1997): \The PCS Option an improvement of the CAT-
future." Manus ript, University of Aarhus.
5. Christensen, C.V. and S hmidli, H. (1998): \Pri ing atastrophe insuran e
produ ts based on a tually reported laims." Working Paper Series No. 16,
Centre for Analyti al Finan e.
6. Cummins, J.D. and Geman, H. (1993) \An Asian option approa h to the val-
uation of insuran e futures ontra ts." Review Futures Markets 13, 517-557.
7. Embre hts, P., C. Kluppelberg and T. Mikos h (1996): `Modelling Extremal
Events for Insuran e and Finan e." Appli ations of Mathemati s 33, Springer,
Berlin
8. Embre hts, P. and S. Meister (1997): \Pri ing insuran e derivatives, the ase of
CAT-futures." In: Se uritization of Insuran e Risk: 1995 Bowles Symposium.
9. Feller, W. (1971): \An introdu tion to Probability Theory and its appli a-
tions." Wiley, Vol. 2. 2nd ed. New York.
10. Gerber, H.U. and E.S.W. Shiu (1996): A tuarial bridges to dynami hedging
and option pri ing. Insuran e: Mathemati s and E onomi s 18, 183-218.
11. S hradin, H. R. und Timpel, M. (1996): \Einsatz von Optionen auf
den PCS-s hadenindex in der Risikosteuerung von Versi herungsunternehmen
12. Tilley, J. A. (1997): \The se uritization of atastrophe property risks." Pro-

eedings, XXVIIth International ASTIN Colloqium, Cairns, Australia.
13. Venter, G. G. (1991): \Premium al ulation impli ation of reinsuran e without
arbitrage." ASTIN Bulletin 21; 223-230.

Aarhus C, Denmark
IMPLIED LOSS DISTRIBUTIONS FOR CATASTROPHE
INSURANCE DERIVATIVES
Abstra t. We analyse pri es for atastrophe insuran e deriva-

tives in the same way as Lane and Mov han [10℄ onsidering the
\implied loss distributions" embedded in the traded pri es. There
are two main problems in this analysis. First, what kind of dis-
tribution should be hosen for the implied losses and, se ond how
should the involved parameters be estimated? In this paper we
give answers to these two questions.
1. Introdu tion
Sin e the introdu tion of the insuran e derivatives in 1992, there have
been a problem pri ing these produ ts and several attempts has been
made, see [1℄, [2℄, [5℄, [6℄, [7℄, [9℄ and [12℄. It has not been possible to
nd a unique model like the Bla k S holes model be ause the underly-
ing annot be des ribed by a distribution as simple as the log normal
and furthermore, the underlying is not traded. The underlying (the
aggregate atastrophe losses, whi h we in the following will denote LT )
would instead most naturally be des ribed by a marked point pro ess
with heavy tail distributed marks. But the problem of su h a model
for the underlying is that the market be omes in omplete and it is
then an open question how the pri ing measure should be determined.
Furthermore, the heavy tailed distribution often gives omputationally
problems, e.g. if the pri ing measure is determined by a representa-
tive agent with an exponential utility fun tion, the marks must have
an exponentially de reasing tail. So, estimating parameters for the
marked point pro ess and al ulating onsistent pri es using a losed
form pri ing model is just now not a workable plan.
We therefore lead our analysis in another dire tion. We follow a pro-
edure familiar to the onventional option market whi h also is sug-
gested by Lane and Mov han in [10℄, namely rather than estimating
volatilities and al ulate onsistent pri es using, say the Bla k S holes
model, take the traded pri es and extra t the volatilities onsistent
with those pri es, i.e. nd the implied volatility. We annot use ex-
a t the same pro edure on the insuran e derivative market, sin e as
Key words and phrases. Implied loss distribution, parameter estimation, rein-
suran e, Catastrophe insuran e derivatives, PCS-options.
1
mentioned above, we are not able to hara terize the pri e by a sin-
gle parameter. But we an do something similar. We an hoose a
model for the implied loss distribution and then estimate the implied
parameters from observed pri es.
dierent pri es and dierent insuran e derivative produ ts. We simply
al ulate implied pri es from the implied loss distributions and ompare
them to the observed pri es. This analysis is very relevant seen in
relation to the re ent trading su ess observed at the Chi ago Board
of Trade (CBoT) ompetitors namely by The Bermuda Commodities
Ex hange (BCOE) and The Catastrophe Risk Ex hange (CATEX).
There are two main problems related to this analysis. First what
kind of distribution should be used for the implied loss distribution
and se ond, how the involved parameters should be estimated. We are
going to answer these two questions in this paper. The data material
used for this analysis are the pri es for the National PCS all spreads
announ ed by the CBoT on January 1st 1999. For a des ription of the
PCS-option see [4℄.
The paper will pro eed as follows. In se tion 2 we will present the
dierent models for the implied loss distributions, in se tion 3 we will
des ribe the pro edure for estimating the parameters, in se tion 4 we
present the data and estimate the parameters, in se tion 5 we evaluate
the dierent models and nally, there are some on luding remarks.
2. The implied loss distribution

In this se tion we present six dierent models for the implied losses.
First, we will give a general des ription of the pri e for a PCS all
spread expressed by the implied loss distribution.
Consider now a PCS all spread expiring at time T with upper and
lower strike Ku and Kl respe tively. Let FeLT and feLT be the implied
distribution fun tion and the implied density fun tion for the aggregate
PCS loss index (LT ) at time T . The value of the PCS all spread at
time 0 is then given by
PKu;Kl (L0 ; 0) = Ee [min(max(LT Kl ; 0); Ku Kl )℄

Z Ku
Kl
The question is now, how is this implied loss distribution of the PCS
index related to the real statisti al distribution, i.e. the distribution
under the P -measure? Before we try to answer this question we on-
sider an example.
IMPLIED LOSS DISTRIBUTIONS 3
Example 2.1. Let the statisti al distribution for the aggregate losses
be des ribed by a ompound Poisson pro ess, i.e.
NT
X
LT = Yi
i=1
where NT Pois(T ), Yi FY and Yi are iid and independent of NT .
We will now pri e the PCS all spread by the approa h of Embre hts
and Meister [9℄. There the general equilibrium approa h is used, where
all the utility fun tions of the agents are of exponential type. More
pre isely, let at time t the pri e of the PCS all spread be given by
PKu;Kl (Lt ; t), the value of the PCS index be given by Lt and the infor-
mation be given by Ft , the pri e at time t see [9℄, is
E [exp (LT ) min(max(LT Kl ; 0); Ku Kl ) j Ft ℄
PKu;Kl (Lt ; t) = P
EP [exp (LT ) j Ft ℄
where is the risk aversion oeÆ ient.
The term exp (LT )=EP [exp (LT ) j Ft ℄ is stri tly positive and inte-
grates to one. Thus it is the Radon-Nikodym derivative dQ=dP of an
equivalent measure. We an therefore express the pri e PKu;Kl (Lt ; t) as
PKu ;Kl (Lt ; t) = EQ [min(max(LT Kl ; 0); Ku Kl ) j Ft ℄
where dQ=dP = exp(LT )=EP [exp(LT ) j Ft ℄. If PKu;Kl (Lt ; t) is the
orre t pri e, the distribution of the PCS index under the risk neutral
measure Q should oin ide with the implied loss distribution. There-
fore, if we are able to nd the distribution of the PCS index under
the risk neutral measure, we are also able to say something about the
implied loss distribution.
Let us now try to nd this distribution. For an introdu tion to
hange of measure methods, we refer to [11℄. Let MY () denote the
moment generating fun tion for Y . By the above denition of the
Q-measure, it follows that 1 i n
Q(NT = n; Yi 2 Ci )
1
= E [exp (LT )1fNT =ng 1fYi 2Ci g ℄
EP [exp (LT )℄ P
n
1 X
= E [exp ( Yi )1fNT =ng 1fYi 2Ci g ℄
EP [exp (LT )℄ P i=1
n
1 Y EP [exp(Yi)1fY 2C g ℄
= MY ()nP (N T = n) i i
exp((MY () 1)) i=1
MY ()
n
1 n ()n Y EP [exp(Y1)1fYi 2Ci g ℄
= MY ( ) e
exp((MY () 1)) n! i=1
MY ( )
n
nY
MY () (MY ()) EP [exp(Y1 )1fYi 2Ci g ℄
= e
n! i=1
MY ( )
Hereby it follows that the pro ess LT is under the new measure Q
a pro ess of the same type but with dierent parameters as under P .
Under Q, NT is a Poisson pro ess with rate MY (R) and the individual
laims have the distribution fun tion FYQ(x) = 0x ey dF (y )=MY ()
(e.g. if Y (; ) then Y ( ; ) under Q). Similar results for
another model an be found in [5℄.
In example 2.1 we nd that the implied loss distribution and the sta-
tisti al distribution are of the same type only with dierent parameters.
It would be onvenient if this were true in general. When modelling
the implied losses, we would only have to look among the models whi h
reasonably ould be used to des ribe the real losses. But is this true in
general?
As mentioned earlier the most natural way to des ribe the real losses
is by a marked point pro ess with positive marks. Let us now re all the
denition of a marked point pro ess. A marked point pro ess with posi-
tive marks is a sequen e (Tn ; Yn)n1 of sto hasti pairs, where T1 ; T2 ; : : :
are non-negative and represent time of o urren e of some phenomena
represented by the non-negative elements Y1 ; Y2; : : : referred to as the
marks of the pro ess. By this denition it follows that if (Tn ; Yn) is
a marked point pro ess with positive marks under P , then (Tn ; Yn) is
a marked point pro ess with positive marks under Q, where Q is an
equivalent measure. So, if the real losses are des ribed by a marked
point pro ess the implied losses should also be des ribed by a marked
point pro ess.
The distribution for the implied losses and the distribution for the
real losses will in general not be the same. But by the dis ussion above,
we will only use models whi h ould reasonably be used to des ribe the
real losses, when we now start to model the implied losses. We now
present six models for the implied losses.
2.1. Model 1. The rst model we will use in our analysis is the same
model as the one suggested by Lane and Mov han [10℄, namely a om-
pound Poisson model with gamma distributed laims, i.e.
NT
X
LeT = Yi
i=1
where LeT are the implied losses, NT Pois(T ) and Yi ( ; ).

This model is also suggested in [1℄, here a losed form pri ing model
are derived in the framework of general e onomi equilibrium theory
under un ertainty.
The ni e thing about this model is that we know the nth onvolution
of the Y 's (Y1 + : : : + Yn (n ; )). This fa t makes the omputations
very simple. A disadvantage of the model is that the laims are light
tailed, whereas data give eviden e that the distribution tail of the ag-
gregate laims is heavy tailed. In this model we an only approximate
a heavy tail by hoosing low values of and .
It is important to have this model in the analysis in order to see
how the result from this model diers from the following and more
ompli ated models. The value of the PCS all spread with strikes Kl
and Ku at time 0 is given by
PKu;Kl (L0 ; 0)
Z Ku
Kl
1 n Z Ku

X
= e n (n ) 1 xn e x dx
n=1
n! Kl
Z 1
+ Ku n (n ) 1 xn 1 e x dx
K
Z 1u
Kl n (n ) 1 xn 1 e x dx
Kl
where L0 = 0.
2.2. Model 2. Looking at the listed all spreads we see, that the one
with the lowest strikes is the 40/60 all spread. The bid and ask for this
all spread is 12 and 15 respe tively, whi h are relatively large values
for a produ t that has a maximal pay-out of 20. These fa ts ould
therefore indi ate that the market expe ts that the loss index will be
above a given threshold K0 for sure. If this is true and K0 > 40,
then there is no market for a 20/40 all spread, be ause the market
will expe t the all spread to be worth 20 for sure. Based on these
indi ations we extend model 1,
NT
X
LeT = K0 + Yi
i=1
where LeT are the implied losses, K0 is a onstant indi ating the thresh-
old the market expe ts the losses to be above for sure, NT Pois(T )
and Yi ( ; ). A ording to the bid of the 40/60 all spread (12),
we will not allow K0 to be above 52 (40+12). A possible interpretation
of this model is to think of K0 as the mean value of the \normal" laims
and of the ompound Poisson pro ess as a model of the ex esses.
The omputations are still very simple. The value of the PCS all
spread with strikes Kl and Ku at time 0 is here given by
PKu;Kl (L0 ; 0)
Z Ku
Kl
1 n Z Ku K0

X
= e n (n ) 1 xn e x dx
n=1
n! (Kl K0 ) +
Z 1
+ (Ku K0 ) n (n ) 1 xn 1 e x dx
K K
Z 1u 0
(Kl K0 ) n (n ) 1 xn 1 e x dx
(Kl K0 )+
re all that we require K0 < 52 so the term (K0 Kl )+ is only in luded
in the pri e of the 40/60 all spread.
2.3. Model 3. The next model will also rely on a light tail distribution
but we will now put more u tuation into the model.
The PCS index an be viewed as the sum of losses from the individual
atastrophes, and the losses from the individual atastrophe an be
viewed as the sum of the individual laims orresponding to this single
atastrophe. We ould therefore model the PCS index LT as
NT X
X Mi
LT = Yij
i=1 j =1
where NT is the number of atastrophes, Mi the number of laims from
the ith atastrophe and Yij is laim size number j from atastrophe
number i. A similar model is also suggested in [6℄, here a losed form
pri ing model are derived and it is shown how the above model an be
used to in orporate the reporting times of the laims.
The number of laims from a atastrophe is P very large, so by the
strong law of the large numbers it follows that M j =1 Yij Mi E [Yij ℄.
i
If the approximation should be good we will also need the Var(Yij )

to be Psmall. If we use this approximation we ould des ribe LT as
LT Ni=1T Mi Y where Y = E [Yij ℄. Motivated by this, we now model
the implied PCS index as
NT
X
LeT = Mi Y
i=1
where NT Pois(T ), Mi NB( ,p) or more pre isely by a mixed
Poisson distribution with a mixing parameter i ( ; ) and Y is
a onstant. We now have a model allowing for more u tuation but
we also have four parameters to estimate. The value of the PCS all

PKu ;Kl (L0 ; 0)
1
X 1
X
= P (NT = n) P (M1 + : : : + Mn = m)g (m)
n=1 m=1
1 1
X n X
= e E [P (M1 + : : : + Mn = m j 1 ; : : : ; n)℄g (m)
n=1
n! m=1
1 1
nX
X
( + : : : + n )m
= e E [e (1 +:::+n ) 1 ℄g (m)
n=1
n! m=1 m!
1 1 Z
nX 1 m
x (x)
X
= e e n (n ) 1 xn 1 e x dx g (m)
n=1
n! m=1 0 m!
1 1 n
X n X (n + m)g (m)
= e
n=1
n! m=1 ( + 1)n +m (n )m!
where g (m) = (mY Kl )+ (mY Ku )+ .
2.4. Model 4. We now onstru t a model allowing heavy tails. We
simply use the same model as model PN1, but we now hoose a Pareto
distribution for the Y 's, i.e. LT = i=1 Yi where NT Pois(T ) and
T
Yi Pa(; ) (fY (x) = ( + x) ). However, there is no losed

form formula for the nth onvolution of the Y s. We solve this problem
by the following approximation. The value of the PCS all spread with
strikes Kl and Ku at time 0 is given by
PKu ;Kl (L0 ; 0)
1 Z Z 1
X
n Ku n n

= e (x Kl )f (x)dx + (Ku Kl ) f (x)dx
n=1
n ! Kl Ku
4 n Z Ku Z 1

X
e
n!
(x K )f n(x)dx + (K
l u Kl ) f n (x)dx
n=1 Kl Ku
where f n (x)denotes the density for the nth onvolution of the Pareto
distribution.
The rst 4 onvolutions are then found by the Rwell-known general
formula forR the Lebesgue
R onvolution (f 2 (x) = 0x f (x y )f (y )dy ,
f 3 (x) = 0x f (x y )( 0y f (y z )f (z )dz )dy , : : : ). By taking the rst
4 onvolutions in the sum only it should be possible for a omputer to
al ulate the expression. And if (the average numberPof atastrophes)
is small, the approximation is good be ause the term 1 n
5 e =n! will
be small.
2.5. Model 5. This model is inspired by the volatility surfa e models
whi h try to explain the volatility smile, i.e. models where the volatility
depends on the strike of the option. We onstru t a similar model
where the most explanatory parameter in the implied loss distribution

is dependent on the strike. We assume that the implied loss index is
Pareto distributed, i.e.
LfT Pa(; )
being just a s ale parameter, the most explanatory parameter in this
loss distribution is the parameter. We therefore hoose to be the
strike dependent parameter, i.e. we assume that is a fun tion of the
strike ((k) = f (K )). The estimation of the parameters is done in four
steps, be ause we have to hose the fun tion f rst. The four steps are
the following
1. We assume that = 0 , i.e. independent of the strike. We then
let LeT P a(0 ; 0 ) and estimate the parameters 0 and 0 .
2. We now keep xed as 0 and then for ea h PCS all spread with
strikes Kli and Kui , we estimate an i from the traded pri e or the
bid/ask spread dependent of what is available. These values are
then plotted. A possible pi ture ould be the one given by gure
2.1.
-
20 40 60 80 100 120 Strike
3. From this plot we hoose a fun tion to des ribe , i.e if we hoose
a fun tion f with three parameters a, b and , a; b; 2 R. We
an now des ribe by (K ) = f (a; b; ; K ). The implied loss
distribution for a PCS all option with strike K is therefore given
by
LeT Pa((K ); )
where (K ) = f (a; b; ; K ).
4. Let now PK (0; L0 ) Rdenote the value of a PCS all option at time
0, i.e. PK (0; L0 ) = K1(x K )feL (x)dx. The value of the PCS all

PKu;Kl (L0 ; 0) = PKl (0; L0 ) PKu (0; L0 )
Z 1 Z 1
= (x Kl )feL (x; Kl )dx (x Ku )feL (x; Ku )dx
Kl Ku
Z 1
= (x Kl )(Kl ) (Kl ) ( + x) (Kl ) 1 dx
Kl
Z 1
(x Ku )(Ku ) (Ku) ( + x) (Ku ) 1 dx
Ku
by use of this expression the parameters a, b and an now be
estimated.
2.6. Model 6. The models 3, 4 and 5 ould also be extended by in-
luding a threshold as it was done for model 1 in model 2. But we will
desist from doing this, as model 3 and 5 will be over parameterized
and model 4 will be omputationally too heavy. We will return to this
dis ussion later. The last model we onsider is a very simple model,
whi h we expe t to be omputationally very fast. It will be interesting
to ompare the results of this model with the results of the other more
ompli ated models. We again in lude a threshold as we did for model
2 and then model LT by
LeT = K0 + YT
where LeT are the implied losses, K0 is a onstant indi ating the thresh-
old the market expe ts the losses to be above almost surely, YT
Pa(; ). Again we will not allow K0 to be above 52. The value of the
PCS all spread with strikes Kl and Ku at time 0 is here given by
PKu ;Kl (L0 ; 0)
Z Ku
= (x Kl )feLT (x)dx
Kl
+ (Ku Kl )(1 FeLT (Ku ))
Z (Ku K0 )
= (x + K0 Kl ) ( + x) 1 dx
(Kl K0 )+
+ (Ku Kl )( ( + (Ku K0 )) )
The above six models are the models we are going to test on our
data. The next step in our analysis is to des ribe the obje tive fun tion
from whi h the parameters should be found. This obje tive fun tion is
des ribed in the next se tion.
3. The obje tive fun tion
Lane and Mov han [10℄ estimate the parameters for the implied loss
distribution by the following pro edure. \The parameters are hosen
su h that they generate pri es that are (i) lower than known oers; (ii)
higher than known bids, and (iii) losest to a tual traded pri es. The
optimization is two-tier. First, get inside the bid-oer spread. Se ond,
get losest to a tual traded pri es. The two-tier ee t is a hieved by at-
ta hing (ideally non-Ar himedean) weights to ea h of the two obje tive
fun tion. \Closest" is dened as the absolute value of the dieren e
between the a tual traded pri e and the theoreti al (or tted) pri es".
We agree that it is desirable that the parameters are hosen su h that
the pri es fulll (i) and (ii), but we do not think that the requirements
should be invariable be ause, if the spreads are very small, it ould be
a problem to nd a solution. And if the theoreti al pri es appear to be
model may be wrong. We also agree on point (iii), i.e. if our data
ontain only traded pri es, the parameters should be found by a least
square t. But the data primarily onsist of spreads and single bids or
asks, we therefore suggest the following obje tive fun tion.
3.1. The obje tive fun tion. The obje tive fun tion O that we pro-
pose be minimized in order to nd the parameters is the following
X P bid P th + 2 X P th P ask + 2
O = i i + i i
P bid P ask
bids i asks i
| {z } | {z }
term 1 term 2
1 X (Pi bid ask
Pi )
+ Æ1
#spreads spreads (Pibid + Piask)=2
| {z }
term 3
X P th (P bid + P ask )=2 2 1
i
Pi
i
bid Pi ask
i ^4
spreads
| {z }
term4
X P th 2P bid + 2
+ Æ2 i i
P bid
single bids i
| {z }
term 5
X 0:5P ask P th + 2
+ Æ2 i i
P ask
single asks i
| {z }
term 6
where the Pith 's are the theoreti al pri es, the Pibid's are the observed
bids and the P ask 's are the observed asks. Æ1 and Æ2 are both onstants.
i
When Pi is a traded pri e, Pi is onsidered as both a bid and an ask
where Pibid = Piask.
Term 1 and 2 are in luded be ause as mentioned above we prefer the
theoreti al pri es to be above the observed bids and below the observed
asks. And as for the optimal ase where we have only traded pri es and
no bid/ask spreads, these two terms alone will give us the ommonly
used least square t.
As long as the average length of the spreads is small we are lose to
the optimal ase where we only have traded pri es and term 1 and 2
will probably be suÆ ient to nd a solution. But if the average length
of the spread is large there is less information about the pri es and we
will probably be unable to nd a unique solution. We therefore add
term 4, in this term we value the information from the bid and the ask
equally, i.e. we prefer the theoreti al pri e to be in the middle of the
bid/ask spread. We ap the single terms in the sum at 1/4, be ause if
Pith = Pibid or Pith = Piask the single term in the sum is equal to 1/4,
and if Pith > Pibid or Pith < Piask then it is punished in term 1 or 2. How
mu h this fourth term should be valued ompared to term 1 and 2 is
then adjusted by term 3. Term 3 is a onstant Æ1 and a term denoting
the average length of the spread. In agreement with the omments
above, we thereby obtain, that if the average length of the spreads is
small, we weight Pith being in the middle less than if the average length
of the spreads is large.
The term 5 and 6 are in luded in order to se ure that the theoreti al
pri es do not get too far away from the single bid's or ask's. By too far
away we mean that a theoreti al pri e is punished if it is lower than
50 % of a single ask or higher than 200 % of a single bid. By the term
Æ2 we are able to adjust how mu h the fth term should be valued
ompared to the other terms.
If we also had information about the volumes that are bid and asked,
it ould be argued that the bid and ask pri es should be weighted by
the orresponding volumes. This is due to the fa t that if the volume
is large, the traders are more on erned about the pri e, and therefore
the pri e should be more a urate. The problem with this argument
is that there is an opposite ee t, namely if the asks are mu h higher
than the \true" pri e, we also expe t the volumes to be large and if
the bids are mu h lower than the \true" pri e, we expe t the volume
to be large. We therefore do not take the volumes into the obje tive
fun tion. We are now ready to estimate the parameters for the models
des ribed in se tion 2 by the above obje tive fun tion. This estimation
is the subje t of the next se tion.
4. The parameter estimation

In this se tion we estimate the parameters and evaluate the six mod-
els des ribed in se tion 2. Before we start to estimate we rst present
the data.
4.1. The data. The data material that we are going to use for this
analysis are the pri es for the National PCS all spreads announ ed by
the CBoT on January 7th 1999.
The rst hange in the underlying PCS index was made January
19th, where the index in reased from 0 to 7.6. We have hosen the
data from January 7th be ause the last hanges in the bids and asks
before January 19th were made here. If we take data from dates after
January 19th we have to take the value of the index into a ount. If we
onsider data from a time point t where the PCS index is greater than
0, some adjustments have to be done. The implied losses at expiration
time T an, at time t, be written as LeT = (LeT Lt ) + Lt , where Lt
is a onstant and LeT Lt is the implied losses in the period from t
to T . LeT Lt an then be des ribed by the same models as we used
to des ribe LeT , but the parameters will probably be hanged. Even
though we are looking at a model where LeT is a stationary pro ess, we
annot expe t the same parameters sin e the PCS index is in uen ed
by some large seasonal ee ts.
The National PCS all spreads announ ed by the CBoT on January
7th 1999 is given by table 4.1.
Call Spreads Kl =KU bid ask

National 40/60 12.0 15.0
National 60/80 6.0 12.0
National 80/100 4.0 8.0
National 100/120 2.8 4.0
National 150/200 4.3 6.0
National 200/250 2.8 4.0
Table 4.1. The National PCS all spread pri es.
4.2. The estimation. The parameters are found by minimizing the

obje tive fun tion, with Æ1 = 0:001 and Æ2 = 0:1. We return to the dis-
ussion of these parameters later. The obje tive fun tion is a fun tion
depending on a higher dimensional variable (the dimension is given
by the number of parameters in the model). We therefore hoose to
minimize it by using a modi ation of the method of steepest de ent
des ribed by Broyden see [3℄ and [8℄.
When we evaluate the models it is important to onsider the om-
puter time used in order to nd the optimum. This time is of ourse
dependent on the hosen initial parameter values, it is therefore not
possible to ompare the omputer times dire tly. But after running
the programs a ouple of times, one gets an indi ation of how fast or
slow the dierent models are. The table below gives a brief indi ation
of how omputationally heavy the models are. The gures in this table
Model Computer time used

1 hours
2 hours
3 days
4 days
5 hours
6 se onds
Table 4.2. The omputer time used.
are very brief. But from the table it is very lear that model 3 and 4
seems to be omputationally heavy ompared to model 1, 2, 5 and 6.
We will keep this in mind for the evaluation of the models. It is not
possible to disqualify any of the models, be ause the omputer times
ould be redu ed with a faster omputer, or by using method tailored
for the problem to solve.
4.3. The theoreti al pri es. We are now ready to estimate the pa-
rameters. The estimation of the parameters for model 1, 2, 3, 4 and 6 is
straightforward. We simply write a omputer program that al ulates
the theoreti al pri es a ording to the above formulas and minimize
the obje tive fun tion a ording to the des ription in [3℄ and [8℄. For
model 5 we have to do the estimation in four steps as des ribed in
se tion 2. In step 1 we nd = 7:66 and = 508. In step 2 we then
set = 508 and estimate the dierent 's, the 's are shown in gure
4.1.
6
-
50 100 150 200 250 300 Strike

In step 3 we then have to hoose a fun tion to des ribe the de-
penden e between the -parameter and the strike value. Figure 4.1
shows that we need at least three parameters to des ribe this de-
penden e. Another thing we have to keep in mind is that the -
parameter has to be positive. We therefore hoose the following fun -
tion (K ) = exp(aK 2 + bK 1 + ) to des ribe the dependen e between
the -parameter and the strike value. With this fun tion we run the
omputer program.
The parameters found by minimizing the obje tive fun tion, the or-
responding mean values and varian es for the implied losses and the
theoreti al pri es are listed in table 4.3, table 4.4 and table 4.5 respe -
tively.
Model par. 1 par. 2 par. 3 par. 4 value

1 = 70 = 0:0123 = 0:0129 0.058
2 = 55 = 0:0050 = 0:0039 x = 47:2 0.00015
3 = 36 = 0:00019 = 0:0266 Y = 0:015 0.086
4 = 2:6 = 3:50 = 90:7 0.060
5 = 58 a = 0:117 b = 4:082 = 0:596 0.013
6 = 24 = 1:25 x = 40:0 0.00010
Table 4.3. The estimated parameters.
M1 M2 M3 M4 M5 M6
Mean value 74 90 77 96 (73;91) 139
Varian e 6096 8453 6178 11652 1 1
Table 4.4. Mean value and varian e.
Kl =KU bid M1 M2 M3 M4 M5 M6 ask

40/60 12.0 9.87 13.56 10.02 9.33 13.57 13.57 15.0
60/80 6.0 7.61 6.55 7.72 7.27 8.00 7.48 12.0
80/100 4.0 5.88 4.82 5.96 5.63 5.49 5.03 8.0
100/120 2.8 4.55 3.78 4.60 4.36 4.07 3.73 4.0
150/200 4.3 5.07 5.07 5.06 4.92 5.08 4.88 6.0
200/250 2.8 2.71 3.35 2.67 2.78 3.41 3.45 4.0
250/300 1.45 2.29 1.41 1.67 2.46 2.64 3.5
300/350 0.78 1.60 0.74 1.06 1.87 2.11 3.0
Table 4.5. The theoreti al pri es.
5. Evaluation of the models

In this se tion we evaluate the results of the estimations from the
previous se tion.
5.1. Model 1. From table 4.5 we see that model 1 is unable to gen-
erate pri es that get into the bid/ask spread of the 40/60 and 200/250
all spreads and we also see that it produ es very low pri es for the
250/300 and 300/350 all spreads. This indi ates that model 1 is a bad
des ription of the implied losses. But re all that this is the model that
was su essfully suggested by Lane and Mov han in [10℄ so why now
this dieren e? In [10℄ they onsider market pri es midyear 1998 where
the PCS index was nearly 40 and this apparently makes a dieren e.
We also tried to model the midyear 1998 pri es with model 1 and our
obje tive fun tion. The results are shown in table 5.1 (The parameter
from [10℄ has been adjusted to orrespond to the index value and not
the Billion $ value).
Kl =KU bid LM CVC ask
40/60 11.0 11.0 12.0
60/80 6.0 7.5 8.2 10.0
80/100 5.7 6.1 8.0
100/120 3.5 4.4 4.6 6.0
100/150 9.4 9.5 12.0
120/140 1.0 3.5 3.5 6.0
250/300 0.5 1.9 1.4 2.5
100/200 14.7 14.4 20.0
150/200 4.0 5.4 4.9 7.5
180/200 0.4 1.8 1.6 1.8
2.23 2.17
0.1887 0.2645
0.0089 0.0124
Table 5.1. The data from [10℄ ontra our data.
From table 5.1 we see that model 1 in our obje tive fun tion also
generates reasonable results for the midyear 1998 pri es. We therefore
on lude that the reason for the bad t of the 1999 pri es is the model
and not the obje tive fun tion. Another important thing to note from
table 5.1 is that there are remarkable dieren es in the pri es obtained
by Lane and Mov han and the pri es we obtain. We thereby see that
the valuation of the bid's and ask's is highly dependent on the hoi e
of the obje tive fun tion.
5.2. Model 2. Looking at the results from model 2 we see a remark-
ably better t. All the pri es are now in the bid/ask spreads and we
also have reasonable pri es for the 250/300 and 300/350 all spreads.
So the shift of the distribution to x = 47:2 apparently has a large ee t.
This is in agreement with the results from [10℄. If we ompare the 1999
pri es with the midyear 1998 pri es we see that they are quite similar,
see table 5.2
Looking at the gures in table 5.2 and re alling that the ompound
Poisson distribution ts the midyear 1998 pri es (where the index value
was 40), it is not suprising that the shifted ompound Poisson distribu-
tion ts the 1999 pri es. Model 1 is a spe ial ase of model 2 (x = 0),
so model 2 will also be able to t the midyear 1998 pri es.
Kl =KU bid99 ask99 bid98 ask98

40/60 11.0 12.0 15.0
60/80 6.0 10.0 6.0 12.0
80/100 8.0 4.0 8.0
100/120 3.5 6.0 2.8 4.0
150/200 4.0 7.5 4.3 6.0
250/300 0.5 2.5 3.5
Table 5.2. The 99 pri es ontra the midyear 98 pri es
5.3. Model 3. From table 4.5 we see that model 3 generates pri es
very similar to model 1, so we do not obtain mu h by in luding the
extra parameter. And as for model 1 we on lude that model 3 is a
bad des ription of the implied losses. As done for model 1 we ould
also extend model 3 by shifting it, but we will desist from doing this
be ause we will then have ve parameters, whi h we onsider too many.
How many parameters one will allow in a model is of ourse individual,
but we set the limit by four. We dis uss this further in the di ussion
of model 5.
5.4. Model 4. A very important thing to note about this model is
that the omputation of the onvolutions is very time onsuming and
this is also why we only in lude the rst four onvolutions in the model.
The pri es we obtain by in luding only the rst four onvolutions are
very similar to the pri es from model 1 and model 3, and as for model
1 and model 3 it is not possible to get into the 40/60 and 200/250 all
spreads. The pri es for the 250/300 and the 300/350 all spreads seem a
little bit better than those forPmodel 1 and 3. The model was justied
by assuming that the term 1 n
5 e =n! should be small. Here the
term is 0.12, whi h an hardly be onsidered small. So, with only four
onvolutions, we onsider the model as a bad des ribtion of the implied
losses.
If we had in luded more onvolutions, 10 say, we would have ex-
pe ted a remarkably better t, but this would have been way to time-
omsuming. The time fa tor is also the reason why we desist from
shifting the distribution.
5.5. Model 5. The rst thing to note from model 5 is the number
of data being very small, whi h therefore makes it hard to really gain
anything from gure 4.1 (the relation between the -parameter and
the strike). The fun tion we hoose based on gure 4.1 is therefore
also very general. The three parameters in luded in the fun tion are
many ompared to the number of data. It is therefore not surprising
that we get a better t than for model 1, 3 and 4, and if we had
in reased the number of parameters even more, say to four or ve, we
would probably also obtain a better t than we did in model 2. But
in reasing the number of parameters does not make the model any
better in relation of des ribing the implied losses. After the estimation
of the pri es for model 5 it is our general impression that model 5 is a
bad des ription of the implied losses. We thereby do not on lude that
there is no strike dependen y on the inplied parameters, but if there
is, it has to be modeled in another way.
5.6. Model 6. It is very fast to ompute the pri es orresponding to
model 6 and the t we obtain is surprisingly good. Suprisingly be ause
it is not a ompound pro ess, but only a shifted Pareto distribution,
and it generates pri es that are better than the pri es from model 2.
But even though the model generates a good t, the pri es are very
dierent from the pri es obtained by model 2. In general it derives
pri es that are higher than the pri es from model 2. The dieren es
in pri es are not surprising if we ompare the mean values and the
varian es from model 1 with the ones from model 6, see table 4.4.
We now have two models both generating reasonable pri es and hav-
ing nearly the same value of the obje tive fun tion. But this is not the
same as saying that the two models are equally good. Based on the
dis ussion in se tion 2, model 2 seems to be the best theoreti ally
founded model. But if we look at the model 2 pri es for the 60/80 and
the 80/100 all spread, one ould get the impression that the implied
distribution from model 2 generates too little risk, whi h indi ates that
model 2 is not a perfe t model.
After this dis ussion we nd that model 2 is the best model to use
even though it is not perfe t. But we also nd that one should use
model 6 simultaneously be ause it is very fast and it ould be used to
support the evaluation of the pri es.
5.7. The Æ1 and Æ2 parameter. How the parameters Æ1 and Æ2 should
be set depends on the data set. If the data set onsist of only bid/ask
spreads and our model generates pri es that are inside these spreads,
then the value of Æ1 has no ee t on the results. But if we have also
traded pri es in our data set, the value of Æ1 gets more important. In
this ase we believe that one should estimate pri es for dierent values
of Æ1 and then set the parameter based on an evaluation of these results.
Model 2 and model 6 both generate results that are inside the bid/ask
spread and the value of Æ1 therefore be omes unimportant for the data
set onsidered in this paper.
The value of Æ2 is set to 0.1, i.e. if the pri es are more than 100%
above a single bid or 50% below a single ask we punish it only 10%
as hard as when the pri es are below or above a bid or an ask. We
nd this value reasonable but again we ould for a given data set try
with dierent values and based on these estimations set the parameter.
But again for model 2 and model 6, the value of Æ2 does not ae t the
results in this paper.
6. Con lusion
We analyse pri es for atastrophe insuran e derivatives by looking
at the \implied loss distributions" embedded in the traded pri es. As
mentioned in the introdu tion there are two main problems in this anal-
ysis. First, what kind of distribution should be hosen for the implied
losses and se ond, how should the involved parameters be estimated?
In relation to how the parameters should be estimated we nd that
an improvement of the pro edure from [10℄ was ne essary be ause of
the following two reasons. First we agree that it is desirable that the
parameters are hosen su h that the pri es are lower than known oers
and higher than known bids, but we do not think that the requirements
should be invariable be ause, if the spreads are very small, it ould be
a problem to nd a solution. And if the theoreti al pri es appear to be
model may be wrong. Se ond we agree on point that the parameters
should be hosen su h that the pri es gets losest to the a tual traded
pri es, i.e. if our data ontain only traded pri es, the parameters should
be found by a least square t. But be ause the data primarily onsists
of spreads and single bids or asks, we nd that this should be in or-
porated in the obje tive fun tion. No matter what obje tive fun tion
one uses, it is lear from the dis ussion of model 1 that the hoi e of
the obje tive fun tion has a large ee t on the derived pri es, and it
should therefore be hosen arefully.
After the dis ussion in the previous se tion we nd that model 1,
suggested by Lane and Mov han [10℄, is unable to t the PCS-option
pri es in general. Instead, we nd that model 2 is a better model to use
for the implied losses. However, it would be preferable to use model
6 also in order to support it. It is lear that none of the suggested
models t the implied losses perfe tly, but we believe that model 2
supported by model 6 will be a good tool for investors analysing pri es
of atastrophe insuran e derivatives.
A knowledgment
The author thanks Uwe for a fruitful dis ussion on the topi .
Referen es
1. Aase, K.K. (1994), An equilibrium model of atastrophe insuran e futures on-
tra ts, Preprint University of Bergen.
2. Barfod, A.M. and D. Lando (1996), On Derivative Contra ts on Catastrophe
Losses, Preprint University of Copenhagen.
3. Broyden, C.G. (1970), The onvergen e lass of double-rank minimization al-
gorithms, J. Inst. Math. Appl.
4. Chi ago Board of Trade (1995), A User's Guide, PCS options.
5. Christensen, C.V. (1999), A new model for pri ing atastrophe insuran e deriva-
tives, Working Paper Series No. 28, Centre for Analyti al Finan e.
6. Christensen, C.V. and S hmidli, H. (1998), Pri ing atastrophe insuran e prod-
u ts based on a tually reported laims, Working Paper Series No. 16, Centre for
Analyti al Finan e.
7. Cummins, J.D. and Geman, H. (1993), An Asian option approa h to the valu-
ation of insuran e futures ontra ts, Review Futures Markets 13, 517-557.
8. Fielding, K. (1970), Fun tion minimization and linear sear h, Communi ation
of the ACM, vol 13 8, 509-510.
9. Embre hts, P. and S. Meister (1997): Pri ing insuran e derivatives, the ase
of CAT-futures. In: Se uritization of Insuran e Risk: 1995 Bowles Symposium.
10. Lane, M. and Mov han, O. (1998), The perfume of the premium II, Sedwi k
Lane Finan ial, Trade Notes.
11. Rolski, T., H. S hmidli, V. S hmidt and J.L. Teugels (1999), Sto hasti pro-
esses for insuran e and nan e. Wiley, Chi hester.
12. S hmo k, U. (1998), Estimating the value of the WINCAT oupons of the Win-
terthur insuran e onvertible bond: A study of the model risk, ASTIN bulletin
29.
13. Tilley, J.A. (1997), The se uritization of atastrophe property risks, Pro eed-
ings, XXVIIth International ASTIN Colloqium, Cairns, Australia.

erations Resear h, University of Aarhus, Ny Munkegade, 8000 Aarhus
C, Denmark
HOW TO HEDGE UNKNOWN RISK
Abstra t. In this paper we are onsidering risk with more than

one prior estimate of the frequen y, e.g. environmental health risk
of new and little known epidemi s, or risk indu ed by s ienti
un ertainty in predi ting the frequen y and severity of atastrophi
events. It is not possible to hedge this kind of risk only using
traditional insuran e pra ti e. A new method is alled for. In
this paper we show how to manage this unknown risk by using
traditional insuran e pra ti e and by trading in the se urity market
simultaneously.
1. Introdu tion
During the last years, the market for risk related to natural phenom-
ena su h as dierent atastrophes has witnessed important hanges.
Su h risk have traditionally been distributed through the insuran e
and reinsuran e system. Insuran e ompanies a umulate the risk of
individual entities and redistribute the risk to the global reinsuran e
industry. But the volatility of weather, taken together with population
movement to warm oastal areas and hange of property pri es has
made atastrophi risk highly unpredi table. It is therefore no longer
possible to diversify this risk using traditional insuran e pra ti es. A
new way to manage su h risk or unknown risk in general is alled for.
When we talk about unknown risk, we refer to risk whi h frequen y
we do not know, i.e. there is more than one estimate of the frequen y
of the risk. Examples of unknown risk are environmental health risk of
new and little known epidemi s, or risk indu ed by s ienti un ertainty
in predi ting the frequen y and severity of atastrophi events.
As we will show in this paper, motivated by [2℄, the way to han-
dle unknown risk is to use two dierent approa hes of hedging risk
simultaneously, namely the statisti al approa h known from the insur-
an e industry and the e onomi approa h known from the se urities
industry.
In this paper we onsider a general model for an insuran e ompany,
where the ompany fa es n states of the world. For ea h of these states
Date : June 30, 1999.
1991 Mathemati s Subje t Classi ation. 91B99.
Key words and phrases. Unknown risk, interplay between insuran e and nan e,
atastrophe insuran e, atastrophe insuran e derivatives.
1
the insuran e ompany is able to estimate the frequen y of the risk,

but the risk related to the states is unknown. We then show how the
ompany should handle this unknown risk. This is done by using the
statisti al approa h to handle the known risk, i.e. the risk related to
a given state. And by using the e onomi approa h to handle the risk
related to the dierent states.
In the next se tion we make the basi assumptions and present the
general model underlying the theory. In se tion 3 we show how to han-
dle the unknown risk in the ase where the market is omplete. We
show how the statisti al approa h and the e onomi approa h are used
simultaneously. It is not always the ase that the insuran e ompany
an harge any premium they want, it is therefore natural to onsider
the ase with a restri ted premium. This ase we onsider in se tion
4 where four dierent ways of hoosing the n state premiums are sug-
gested. These four dierent hoi es are then evaluated in se tion 5 and
6. In se tion 7 we onsider the in omplete market ase and nally there
are some on luding remarks.
2. The Model
Let S denote the state of the world. We make the following assump-
tions:
There are n states denoted by fs1; : : : ; sng; S 2 fs1; : : : ; sng.
The probabilities orresponding to the n states are known
n
X
P (S = si ) = pi ; i = 1; : : : ; n; pi = 1
i=1
Fi is known for all i 2 f1; : : : ; ng, where Fi denotes the distribu-
tion of the loss (L) of the insuran e ompanies given the state is
i (LjfS = si g Fi ). Let Li = LjfS = si g.
If the insuran e ompany knows the state S then the statisti al
approa h by adding a safety loading would work, i.e. if the insur-
an e ompany knew that S = si it would be reasonable to harge
the premium Pi given by
Pi = E [Li ℄ + Æi
where Æi is a safety loading al ulated by a standard premium
al ulation prin iple.
There exist n \state se urities" traded on the n states. Se urity
number j pays the amount ij if the state is i. Let i be the ve tor
i = ( i1 ; : : : ; in ) and let C be the matrix given by
2
1 3
C = 4 ... 5
n
HOW TO HEDGE UNKNOWN RISK 3
Let further ~j be the j th olumn in C .

The market is omplete, i.e. the n olumns in C are linearly
independent.
The market for these se urities is arbitrage free and there exists an
unique risk neutral measure. We denote the risk neutral probabili-
ties by q1 ; : : : ; qn , and let q be the ve tor given by q = (q1 ; : : : ; qn ).
From basi nan e ourses it is known that these risk neutral prob-
abilities an be used to pri e the state se urities, i.e. the pri e of
state se urity number i is given by the dis ounted value of q ~j .
There exists a risk free se urity and for simpli ity we assume that
the risk free interest rate is zero. This is no loss of generality
be ause we an dis ount all se urities.
We now have a model where the insuran e ompany exa tly knows
how they should handle the insuran e risk if the state of the world is
known. But be ause of the un ertainty on the state of the world the
general risk for the insuran e ompany be omes unknown. In the next
se tion we will show how the insuran e ompany is able to handle this
unknown risk.
3. How to handle unknown risk in a omplete market

The expe ted loss for the insuran e ompany is given by
E [L℄ = p1 E [L1 ℄ + + pn E [Ln ℄
To over these losses the insuran e ompany has to harge a premium
P , but harging a premium is not enough. Be ause if the insuran e
ompany harges a premium P we obtain a safety loading in state i
given by Æ~i = P E [Li ℄. The problem by this is that we do not obtain
the desired safety loading. For some i's we have that Æi < Æ~i whi h
means that the insuran e ompany has been over harging. And for
some i's we have that Æi > Æ~i whi h means that the insuran e ompany
has been under harging, whi h ould lead to a dangerous position.
Before we solve this problem we make the two following denitions.
Denition 3.1. A trading strategy for the insuran e ompany is
dened as a ve tor m = (m1 ; : : : ; mn )T where mi denotes how many
se urities i the insuran e ompany buys.
Denition 3.2. An optimal trading strategy for the insuran e
ompany is a ostless trading strategy su h that
P + i m E [Li ℄ = Æi 8i = 1; ; n: (3.3)
The question is now whether it is possible to obtain this optimal
strategy and if it is, what premium should be harged in order to
obtain it? These questions is answered in the following theorem.
Theorem 3.4. An optimal trading strategy an be obtained if and only

if
P = q1 P1 + + qn Pn:
In this ase, the strategy m has to be hosen by 3.5.
Proof. We rst show the if part. Assume that the insuran e ompany
harge the premium P given by P = q1 P1 + + qn Pn . We then show
that there exist a trading strategy m = (m1 ; : : : ; mn )T that solves
ondition (3.3) in denition (3.2). m if found by solving the following
equation
2
P 3 2 E [L1 ℄ 3 2 11 : : : 1n 3 2 m1 3 2 Æ1 3
4 ... 5 4 .. 5 + 4 .. . . . .. 5 4 .. 5 = 4 .. 5 :
. . . . .
P E [Ln ℄ n1 : : : nn mn Æn
The market is omplete, C is therefore invertible. A solution exists and
is given by
2
P + E [L1 ℄ + Æ1 3
m = C 14 .. 5: (3.5)
.
P + E [Ln ℄ + Æn
It now remains to show that this trading strategy is ostless. The value
of the ith se urity is the expe ted value of the payo al ulated under
the risk neutral measure. Let vi denote the value of the ith se urity
vi = q ~j :
Let v be given by v = (v1 ; : : : ; vn ). The ost of the portfolio is then
given by
Cost of pf. = vm
2
P + E [L1 ℄ + Æ1 3
= qCC 1 4 .. 5
.
P + E [Ln ℄ + Æn
n
X
= qi ( P + E [Li ℄ + Æi )
i=1
n
X n
X
= P qi + qi Pi = 0:
i=1 i=1
We now show the only if part. Assume therefore that there exist an
optimal trading strategy. Equation (3.5) then holds and vm = 0. Using
this and that v = qC we obtain
n
X
qi ( P + E [Li ℄ + Æi ) = 0
i=1
and rearranging the terms we obtain
P = q1 P1 + + qn Pn
Remark 3.6. The problem an be simplied if we onsider it in the

following way. The insuran e ompany wants to obtain the premiums
(P1 ; : : : ; Pn) orresponding to the n states. This ould be obtained for
all i if we for all i buy Pi of Arrow-Debreu (AD) se urity number i.
AD se urity i is a se urity that pays 1 if the state is i and pays zero
in all other states. These AD se urities exist be ause the market is
omplete, and the pri e of AD se urity number i is given by qi . The
total pri e of this AD portfolio is therefore given by
n
X
Total pri e = Pi qi
i=1
Pn
So by harging a premium P = i=1 Pi qi
the insuran e ompany an
obtain the optimal strategy. This only works if the market is omplete,
we will return to the in omplete ase later.
4. The restri ted premium ase
In the previous se tion we found the optimal premium to harge for
the insuran e ompany. But the insuran e ompany may be unable to
harge this premium be ause of some ompetitive reasons. We therefore
now assume that the premium whi h the insuran e ompany an harge
is xed at P0 .
The insuran e ompany should therefore now hoose a trading strat-
egy whi h they nd \optimal" under the restri tion that the ost of the
trading strategy equals P0 . What we mean by \optimal" is dis ussed
later in this se tion. In this omplete market ase hoosing a trading
strategy m is equivalent to hoosing premiums (P1 ; : : : ; Pn). We have
the following relation between (P1 ; : : : ; Pn) and m
(P1 ; : : : ; Pn)T = Cm:
The restri tion an also be expressed in terms of the Pi 's instead of m.
vm = P0
) qCC 1(P1; : : : ; Pn)T = P0
) q1P1 + + qn Pn = P0:
These observations now allows us to reformulate the problem to a prob-
lem in terms of the premiums (P1 ; : : : ; Pn ) instead of a problem in term
of the trading strategy m.
The problem in this xed premium ase is therefore to nd the \op-
timal" hoi e of the Pi 's subje t to the onstrain P0 = P1 q1 + + Pn qn .
We will now onsider four dierent ways of solving this optimal pre-
mium hoi e (OPC), i.e. dening \optimal". In the following we let
Oi denote the dieren e between the premium re eived in state i and

the losses paid in state i, i.e. Oi = Pi Li .
4.1. OPC1: Equal risk quantity in all states. The goal here is
to obtain the same risk quantity in all the states. To measure the risk
quantity we will use the mean divided by the standard deviation, i.e.
high value of the quantity orresponds to a low risk. The solution to
OPC1 is found by solving the following n equations with n unknowns:
E [O1 ℄ E [O ℄
p =p i ; i = 2; : : : ; n
Var(O1 ) Var(Oi)
P0 = P1 q1 + + Pn qn
Note that we here have V ar(Oi) = V ar(Li ). OPC1 therefore ensures
that expe ted gain E [Pi Li ℄ will be high in states where V ar(Li ) is
large, i.e. we obtain a high gain in the risky states.
4.2. OPC2: Equal ruin probabilities in all states. The goal here
is to obtain the same ruin probabilities in all the states. The ruin
probabilities are usually al ulated a ording to the initial apital, we
therefore in lude the initial apital u in the OPC. The solution is found
by solving the following n equations with n unknowns:
P (O1 + u < 0) = P (Oi + u < 0); i = 2; : : : ; n

P0 = P1 q1 + + Pn qn
4.3. OPC3: Equal expe ted utility in all states. The goal here
is to obtain the same expe ted utility in all the states. In order to
solve the problem we have to hoose a utility fun tion. Let the utility
fun tion be given by v (x); x 2 R, where we assume, v (0) = 0 (only for
onvenien e), v 0 > 0 (less losses are preferred) and v 00 < 0 (stronger
weights for higher losses). The solution is found by solving the following
n equations with n unknowns:
E [v (u + O1 )℄ = E [v (u + Oi )℄; i = 2; : : : ; n
P0 = P1 q1 + + Pnqn
4.4. OPC4: Maximal expe ted utility. The goal here is to obtain
the maximal expe ted utility. We have the same utility fun tion as in
OPC3, but we now have to solve the following maximization problem:
max E [v (u + Ps Ls )℄
st P0 = P1 q1 + + Pn qn
We have now stated four dierent ways of solving the OPC, but
whi h one is the best? At rst it seems most natural to use OPC4,
i.e. maximize the expe ted utility. But a problem by this approa h
is that when we only onsider the general expe ted utility we ould
end up with some very risky individual states. One ould imagine a
situation where the insuran e ompany maximizes its expe ted utility
and thereby obtains a very large ruin probability in one of the states.
Su h a premium hoi e ould then, be ause of the high ruin probability,
be refused by shareholders, authorities or the like. OPC4 is therefore
not ne essarily the best OPC to use in general. In the following we will
analyse the OPC's further.
5. Solutions of the different OPC's

In this se tion we will try to evaluate and ompare the dierent
OPC's. This is done by rst solving the dierent OPC's one by one, and
then se ondly ompare them by an example where dierent premiums
are al ulated.
5.1. Solution of OPC1. Let now i denote the p mean value and i
denote the standard deviation of Li . We then have Var(Oi ) = i and
OPC1 an now be written as
P1 1 Pi i
= ; i = 2; : : : ; n
1 i
P0 = P1 q1 + + Pnqn
The general solution to these n equations with n unknowns is given by
Pi = ai P1 + bi ; i = 2; : : : ; n
P q b qn bn
P1 = 0 2 2
q1 + q2 a2 + + qn an
where ai = i =1 and bi = i ai 1 .

OPC1 is easy to solve, and it only requires that the rst two moments
Pn From the solution we see that Pi is
of all the loss distributions exists.
in reasing in i and if P0 > i=1 qi i also in reasing in i . This also
seems intuitively lear. Here the risk measure must be the same for
all the states, the premium for state i is therefore expe ted to in rease
if the mean value or the standard deviation orresponding to state i
in reases.
5.2. Solution of OPC2. Consider rst

P(Oi + u < 0)
= P(Pi Li + u < 0) = P(Li > Pi + u) = 1 Fi (Pi + u)
OPC2 an therefore be written as

F1 (P1 + u) = Fi (Pi + u); i = 2; : : : ; n
P0 = P1 q1 + + Pn qn
Plugging the (n 1) equations into equation number n we obtain
n
X
qi Fi 1 (F1 (P1 + u)) = P0 + u
i=1
Let then G(x) be given by
X
G(x) = qi Fi 1 (F1 (x))
i=1
G(x) is then in reasing, hen e invertible. In the ases where Fi is
ontinuous the solution is given by
P1 = G 1 (P0 + u) u
Pi = Fi 1 (F1 (P1 + u)) u
If Fi is not ontinuous, it may happen that no solution exists.
Remark 5.1. An alternative way of solve the problem, will be to solve
the problem numeri ally by setting up the following minimization prob-
lem
n
X
min (F1 (P1 + u) Fi (Pi + u))2 + (P0 P1 q1 Pnqn)2
i=2
Note that the solution to the minimization problem is only a solution
to the OPC2 problem if the optimal value is 0.
5.3. Solution of OPC3. We rst solve OPC3 in general, i.e. where
the only assumption we have on the utility fun tion is that v (0) = 0,
v 0 > 0 and v 00 < 0. Let now gi (x) be given by
gi (x) = E [v (x Li + u)℄
gi (x) is then stri tly in reasing and ontinuous, hen e the inverse ex-
ists, and is also stri tly in reasing and ontinuous. The n equations
orresponding to OPC3 an therefore be written as
Pi = gi 1(g1 (P1 )); i = 2; : : : ; n

n
X
P0 = qi gi 1 (g1 (P1 )):
i=1
Let now G(x) be given by
n
X
G(x) = qi gi 1 (gi (x)):
i=1
G(x) is then in reasing, hen e invertible and the solution is given by

P1 = G 1 (P0 ):
We now have a general solution of OPC3. In the next part of this
se tion we onsider OPC3 with a further assumption, namely that the
Pi 's has to be independent of u. How this assumption will restri t our
hoi e of the utility fun tion is shown by the following lemma.
Lemma 5.2. The Pi 's that solves OPC3 are independent of u for all
distributions of Li and all hoi es of q1 ; : : : ; qn if and only if v (x) =
A(1 e x ) for some A > 0 and > 0.
Proof. Assume that v (x) = A(1 e x ). We then have to solve the
following problem
E [A(1 e (P L +u) )℄ = E [A(1 e (Pi Li +u) )℄;
1 1
i = 2; : : : ; n
P0 = P1 q1 + + Pn qn
These equations are equivalent to
E [A(1 e (P L ) )℄ = E [A(1 e (Pi Li ) )℄;
1 1
i = 2; : : : ; n
P0 = P1 q1 + + Pn qn (5.3)
We here see that the Pi 's are independent of u.
Assume that the Pi 's are independent of u. Let there be two states
and two orresponding AD pri es q1 and q2 (q1 + q2 = 1). Let P (L1 =
2) = 1 P (L1 = 0) = r and P (L2 = 1) = 1. P1 and P2 are now
dependent on r and we will therefore in the following denote them
P1 (r) and P2 (r). The OPC3 an now be written as
rv (u + P1 (r) 2) + (1 r)v (u + P1 (r)) = v (u + P2 (r) 1)
q1 P1 (r) + q2 P2 (r) = P0
From the se ond equation we an express P2 (r) in terms of P1 (r) . This
expression is used in the rst equation to obtain
rv (u + P1 (r) 2) + (1 r)v (u + P1 (r)) =
P q P (r )
v (u + 0 1 1 1): (5.4)
q2
Taking the derivative of (5.4) with respe t to u yields
rv 0 (u + P1 (r) 2) + (1 r)v 0 (u + P1 (r)) =
P q P (r )
v 0 (u + 0 1 1 1): (5.5)
q2
The derivative of (5.4) with respe t to r is
v (u + P1 (r) 2) v (u + P1 (r)) + P10 (r)rv 0(u + P1 (r) 2)+
P10 (r)(1 r)v 0 (u + P1 (r)) = qq P10 (r)v 0 (u + P qq P (r) 1): (5.6)
1
2
0 1
2
1
Plugging in (5.5) in (5.6) yields

v (u + P1 (r) 2) v (u + P1 (r)) +
1 0 0 P q P (r )
P1 (r )v (u + 0 1 1 1) = 0: (5.7)
q2 q2
Note that P10 (r) > 0 follows immediately. The derivative of (5.7) with
respe t to u is
v 0 (u + P1 (r) 2) v 0 (u + P1 (r)) +
1 0 00 P q P (r )
P1 (r )v (u + 0 1 1 1) = 0: (5.8)
q2 q2
and from the derivative with respe t to r it follows that
1 0 2 00 P q P (r )
2 P1 (r ) v (u + 0 1 1 1) +
q2 q2
1 00 0 P q P (r )
P1 (r)v (u + 0 1 1 1) = 0:
q2 q2
Thus P100 (r) 0 and if we substitute x = u + P qq P (r) 1 we get
0 1
2
1
P 00 (r) v 00 (x)
q2 10 2 = 0 :
P1 (r) v (x)
The right hand side is independent of r and the left hand side is inde-
pendent of x. The left hand side and the right side is therefore both
independent of r and x. And from this we on lude
v 00 (x)
=
v 0 (x)
for some 0 and the assertion follows.
Example 5.9. If we now set v (x) = A(1 e x ) we are able to nd
a losed solution to OPC3. Let MLi () denote the moment generating
fun tion of Li at the point . From (5.3) we then know that OPC3
an be written as
1 ML ( )
Pi = P1 ln(
1
); i = 2; : : : ; n
MLi ()
P0 = P1 q1 + + Pn qn
We now have a problem equivalent to OPC1 and the general solution
is therefore given by
1
P1 = P0 + (q2 ln(a2 ) + + qn ln(an ))

1
Pi = P1 ln(ai ); i = 2; : : : ; n

L ()
where ai = M MLi () .
1
Remark 5.10. A problem of the exponential utility fun tion is that it

only allows for loss distributions where the moment generating fun tion
exists. This means that for heavy tailed loss distributions we need to
hoose another utility fun tion, e.g. the power utility fun tion. If we
do so the OPC3 be omes dependent of u and also mu h harder to solve.
In most of the ases the solution will have to be found numeri ally.
5.4. Solution of OPC4. As for OPC3 we rst solve OPC4 in general.
max p1 E [v (u + P1 L1 )℄ + + pn E [v (u + Pn Ln )℄
st P0 = P1 q1 + + Pn qn
In order to solve this problem we onstru t the Lagrange fun tion
F (P1 ; : : : ; Pn) = p1 E [v (u + P1 L1 )℄ + + pn E [v (u + Pn Ln )℄
+(P0 P1 q1 Pn qn )
The next step is to onstru t the rst and se ond order ondition or-
responding to the maximization problem. The rst order ondition:
F
= p1 E [v 0 (u + P1 L1 )℄ q1 = 0
P1
..
.
F
= pn E [v 0 (u + Pn Ln )℄ qn = 0
Pn
F
= P0 P1 q1 Pn qn = 0

Let now gi(x) = E [v 0 (u + x Li )℄, then gi (x) is stri tly de reasing
and ontinuous, hen e the inverse exists, whi h also is ontinuous and
de reasing. From equation number 1 and i, i = 2; : : : ; n we get
pq
Pi = gi 1( 1 i g1 (P1 )): (5.11)
pi q1
P1 is found by plugging (5.11) into the onstraint, i.e. from the equation
pq pq
P0 = q1 P1 + q2 g2 1 ( 1 2 g1 (P1 )) + + qn gn 1 ( 1 n g1 (P1 )):
p2 q 1 pn q 1
1 p q
Note that q1 P1 and qi gi ( pi q i g1 (P1 )) for all i are stri tly in reasing in
1
1
P1 . It is therefore possible to nd a solution to this equation.
We now have a solution. In order to he k whether it is optimal we
he k the se ond order ondition. To he k the se ond order ondition,
for a minimization problem with an equality onstraint, we have to
onstru t the so alled bordered determinants, see [3℄ (p. 382). They
are obtained by bordering the prin ipal minors of the Hessian deter-
minant of se ond partial derivatives of the Lagrange fun tion by a row
and a olumn ontaining the rst partial derivatives of the onstraint.
The element in the southeast orner of ea h of these arrays is zero.
The se ond order ondition for the problem is then satised if these
bordered determinants alternate in sign, starting with plus, i.e. the
sign of the determinants below must taken from above be +,{,+, et .
2 3
p1 E [v 00 (u + P1 L1 )℄ 0 q1
4 0 00
p2 E [v (u + P2 L2 )℄ q2 5
q1 q2 0
..
. 2 3
p1 E [v 00 (u + P1 L1 )℄ : : : 0 q1
6 .. ... .. .. 7
6 . . . 7
4 0 : : : pn E [v 00 (u + Pn Ln )℄ qn 5
q1 ::: qn 0
It follows easily from the bordering determinants above that the se ond
order ondition is fullled.
In the following example we solve the problem expli itly for the ex-
ponential utility fun tion.
Example 5.12. As for OPC3 we now solve OPC4 expli itly for v (x) =
A(1 e x ). The OPC4 problem then takes the following form:
max 1 p1 E [e (P L ) ℄ pn E [e (Pn
1 1 Ln ) ℄
st P0 = P1 q1 + + Pn qn
As before we rst onstru t the Lagrange fun tion
F (P1 ; : : : ; Pn ) = 1 p1 ML ()e 1
P1 pnMLn ()e Pn
+(P0 P1 q1 Pnqn )
The next step is then to onstru t the rst and se ond order ondition
orresponding to the maximization problem. The rst order ondition
as before:
F
= p1 ML ()e P q1 = 0 1
P1 1
..
.
F
= pn MLn ()e Pn qn = 0
Pn
F
= P0 P1 q1 Pn qn = 0

From equation number 1 and i, i = 2; : : : ; n we get
1 p q M ( )
Pi = P1 ln ai ; where ai = 1 i L : (5.13) 1
pi q1 MLi ()
Plugging (5.13) into the onstraint we obtain

1
P1 = P0 + (q2 ln(a2 ) + + qn ln(an ))

We now have a solution and we know from the general solution that it is
optimal. So again we obtain a ni e solution for the exponential utility
fun tion. But as for OPC3 the solution only work for distribution
where the moment generating fun tion exist. Note that for general
utility fun tions, solutions may have to be found numeri ally.
We are now ready to evaluate the four OPC's.
6. Evaluation of the OPS's
In this se tion we try to evaluate the dierent OPC's. This is done by
onstru ting two dierent examples. In the rst example we onsider
a model with three dierent states. The losses orresponding to these
states follow an exponential distribution, and two dierent gamma dis-
tributions, respe tively. These light tailed distributions allow us to use
the exponential utility fun tion in OPC3 and OPC4. We are therefore
able to ompare all the dierent OPC's in this example. In the other
example we in lude a heavy tailed distribution. We here onsider two
states, the losses in state two follow a Pareto distribution whereas the
losses in state one still follow a light tailed distribution namely the
exponential. When we in lude a heavy tailed distribution we are no
longer able to use the exponential utility fun tion. We therefore only
ompare OPC1 and OPC2 in this example.
6.1. Example 1. We start this example by spe ifying the distribu-
tion of the state losses and their mean values, varian es and moment
generating fun tions. The possible premium (P0 ) is set to 1:2 EP [L℄
(P0 = 7:44).
L1 L2 L3
Distribution Exp(1) (5,1) (2,0.1)
Mean value 1 5 20
Varian e 1 5 200
MLi () ( 1 1 ) ( 1 1 )5 ( 0:01:1 )2
We further assume that the p probabilities are given by p1 = 0:45,

p2 = 0:35 and p3 = 0:2. But before we set the q probabilities re all
the following. The q probabilities an be seen as the pri es of the AD
se urities. The q probabilities are therefore set by the agents in the
market. Some of the agents trading in this market will be people from
the insuran e market, i.e. people who will be needing money if the
world end up in state 3. We therefore expe t the pri e of AD se urity
3 (q3 ) to be higher than p3 and as a onsequen e of this q1 and/or q2

to be lower than p1 and/or p2 . With this in mind we now assume that
the preferen es in the market determines the following q probabilities
q1 = 0:044, q2 = 0:0345 and q3 = 0:0215. We have now set all the
parameter and are therefore ready to al ulate the dierent OPC.
In table 1 the dierent OPC are stated. For OPC2 we have hosen
dierent values for the initial apital, and similar for OPC3/4 we have
hosen dierent values for the risk aversion oeÆ ient .
OPC number spe ial parameter P1 P2 P3
1 1.022 5.108 24.318
2 u=0 1.118 5.701 23.168
2 u=1 0.356 5.212 25.512
2 u = 10 -6.224 3.742 46.742
3 = 0:09 -4.782 -0.590 45.339
3 = 0:05 0.284 4.387 26.984
3 = 0:03341 1.022 5.090 24.346
3 = 0:03075 1.118 5.181 24.002
3 = 0:03 1.145 5.206 23.908
3 = 0:01 1.739 5.759 21.806
3 = 0:001 1.953 5.955 21.053
3 = 0:0001 1.973 5.973 20.983
4 = 0:09 -4.525 -0.423 44.543
4 = 0:05 0.747 4.689 25.551
4 = 0:04549 1.022 4.938 24.591
4 = 0:04384 1.118 5.024 24.255
4 = 0:03 1.917 5.709 21.520
4 = 0:01 4.056 7.267 14.643
4 = 0:001 25.122 21.040 -50.571
Table 1. The OPC's for example 1
From table 1 we see that the safety loadings orresponding to state

1,2 and 3 for OPC1 are set to 2%, 2% and 22% respe tively. The
safety loadings are the same for state 1 and state 2. This is just as we
expe t, be ause they have the same ratio between the mean value and
the varian e. The safety loading for state 3 is mu h larger, this means
that OPC1, as preferred, takes the higher risk in state 3 into a ount.
How OPC1 hanges when the risk in state 1 be omes more and more
heavy tailed is onsidered in example 2.
Consider now OPC2. For u = 0 the safety loadings are 12%, 14%
and 16% for state 1, 2 and 3 respe tively. This means that OPC2 for
u = 0 do not spe ially ompensate for the higher risk in state 3. But
if we in rease the initial apital, we see that the premium in state 3
in reases. It is preferable to have a OPC that ompensates for the

higher risk in state 3. But the question is how large a ompensation
is desirable? We see that for high values of u OPC2 suggest that we
start selling out of AD se urity 1 in order to buy more of AD se urity
3. We hereby obtain a low ruin probability in all states but also the
probability of loosing money on the sold AD se urities. For some it will
probably be better to a ept a higher ruin probability in state 3 and
then not to sell as many of AD se urity 1. If this is the ase one should
hoose the u arefully or go for another OPC. The hoi e of u ould
also lead to other problem for OPC2, whi h we return to in example 2.
We now turn to OPC3. When we hose the risk aversion parameter
() we have to remember that has to be below 0.1 otherwise the
moment generating fun tion for the loss in state 3 does not exist. Values
of lose to 0.1 therefore orresponds to a high risk aversion. For
= 0:09 we also see a very risk averse behaviour. Here the agent fears
state 3 so mu h that he sells out of AD se urity 1 and 2 in order to buy
more of AD se urity 3. For lower values of the risk aversion the safety
loading in state 3 de reases. The values of = 0:03341 and = 0:03075
are in luded in the table in order to see how OPC 3 is related to
OPC1 and OPC2. For the two values we obtain P1OP C 3 = P1OP C 1 and
P1OP C 3 = P1OP C 2, but we also see that is not possible to nd a su h
that the all Pi 's are equal, but for = 0:03341 OPC1 and OPC3 are
very similar. For ! 0, i.e. if we moving towards a risk neutral
behaviour we see that the Pi 's are onverging. It an be shown that
the limits are given by
Pi = E [Li ℄ + P0 EQ [L℄
= E [Li ℄ + 0:975
This is also what we expe t, an agent with a risk neutral behaviour
allo ates the same amount of safety loading in all the states.
Finally onsider OPC4. When we onsider OPC4 we have to remem-
ber that OPC4 both in lude the p and the q probabilities. This means
that the premium hoi es for an agent using OPC4 be omes depended
on how he evaluates the market pri es, i.e. how his preferen es are
ompared to the preferen es of the representative agent. This means
that if the agent onsider the pri e of AD se urity i (qi ) to low om-
pared to his own preferen es he will be buying more of AD se urity i.
But when he buys more of AD se urity i his portfolio hanges and at
some level he will onsider the pri e to high. So when we now evaluate
OPC4 we will have to remember that the agent maximize his utility
and evaluate the pri es (the q probabilities) at the same time.
For a high risk aversion oeÆ ient we see, as for OPC3, that the
agent sells out of AD se urity 1 and 2 in order to buy more of AD
se urity 3. We also see that for = 0:09 P3 is lower for OPC4 than
for OPC3. The reason for this is as mentioned above that when the
agent using OPC4 obtain a premium P3 = 44:543 in state 3 he starts
onsidering the pri e of AD se urity 3 (q3 ) to high.
The values of = 0:04549 and = 0:04384 are in luded in the table
in order to see how OPC 4 is related to OPC1 and OPC2. For the
two values we obtain P1OP C 3 = P1OP C 1 and P1OP C 3 = P1OP C 2. We here
observe that OPC4 put more weight into state 3 that both OPC1 and
OPC2.
Finally we see that for ! 0, i.e. we are moving towards a risk
neutral behaviour the agent, as expe ted, onsiders the pri e of AD
se urity 3 higher and higher. He therefore sets P3 lower and lower, i.e.
selling more and more of AD se urity 3.
6.2. Example 2. As mentioned above we here assume that the total
losses in state 1 is exponentially distributed (L1 Exp(1 )) and the
total losses in state 2 is Pareto distributed (L2 Pa(2 ; 2 )). The
possible premium (P0 ) is here set to 1:2 EQ [L℄ and the q probabilities
are set to q1 = 0:75 and q2 = 0:25. In this example we onsider three
dierent values for the parameters. This is done in order to see how
the two OPC's (OPC1 and OPC2) dier when the loss distribution in
state 2 be omes more and more heavy tailed. The parameter values,
the mean values and the varian es for the Li 's, the OPC, the risk
quantity's and the ruin probabilities are all given in the table below.
OPC2 is solved for dierent values of the initial apital. The value of
the u's are given in the table.
If we rst onsider OPC1, we see that the value of P2 in reases and
the risk quantity de reases when L2 be omes more and more heavy
tailed. So again OPC1 works the way we want, i.e. we have a relatively
large safety loading in the states where our risk is high.
We now onsider OPC2. Here the pi ture is dierent. For u = 0
and u = 10 we surprisingly observe that the the value of P2 and the
ruin probability both de reases when L2 be omes more and more heavy
tailed. But for u = 20 we observe a more preferable behaviour, namely
that P2 and the ruin probability both in reases when L2 be omes more
and more heavy tailed. The reason for the \bad" OPC for u = 0 and
u = 10 must be found in the shape of the distribution fun tions. In
gure 1 and gure 2 P (L < P + u) (1-"the ruin probability") are shown
for u = 0 and u = 20 respe tively. The labels orresponds to the fol-
lowing distributions of L Exp(0:1)(0), Pa(6; 50)(1) and Pa(2:1; 11)(3).
The horizontal lines are the levels of the survival probability (1-ruin
probability) for OPC2.
If we start analysing gure 1, it be omes lear why we observe the
de reasing P2 when L2 be omes heavier tailed. Be ause of the low val-
ues of the initial apital we have a relative low level of the distribution
0.8
0.6
0.4
0.2
0 20 40
Figure 1. The shape of the distribution fun tions for

u = 0.
1
0.9
0 30 60
Figure 2. The shape of the distribution fun tions for

u = 20.
Case 1 Case 2 Case 3

1 0.1 0.1 0.1
2 6 3 2.1
2 50 20 11
E [L1 ℄ 10 10 10
V ar(L1 ) 100 100 100
E [L2 ℄ 10 10 10
V ar(L2 ) 150 300 2100
OPT1 P1 11.89 11.69 11.06
OPC1 P2 12.32 12.93 14.83
risk quantity 0.19 0.17 0.11
OPC2 P1 (u = 0) 12.23 12.54 12.89
OPC2 P2 (u = 0) 11.31 10.38 9.32
Ruin probability 0.294 0.285 0.276
OPC2 P1 (u = 10) 11.97 12.08 12.36
OPC2 P2 (u = 10) 12.10 11.75 10.91
OPC2 P1 (u = 20) 11.27 10.75 10.59
OPC2 P2 (u = 20) 14.20 15.75 16.22
Table 2. The OPC's for example 2
fun tion in equilibrium. At this levels the urve of the ase 3 Pareto
distribution fun tion is above the urve of the ase 1 Pareto distribu-
tion fun tion. We therefore observe the de reasing P2 's. But when we
in rease the initial apital and thereby in rease the survival probability
the pi ture hanges. At this level the fat tail is taking over, and we
get the desired ee t namely that P2 in reases when the tail is getting
fatter.
We now on lude that the simple OPC1 is easy to al ulate, and it
works reasonable. OPC2 is more ompli ated to al ulate and we have
to be more areful when we use it, be ause it is highly depended on
the initial apital. But with a \suitable" level of the initial apital we
have seen that it works well. It is not possible to say whether OPC1
or OPC2 is best in general.
6.3. Example 3. As seen above, it is not possible to rank the dierent
OPC's. But in this example we will try to do it for an agent that weights
all four OPC's equally and who has a known utility fun tion.
Let the situation be as in example 1. We further assume that the
onsidered agent has an exponential utility fun tion with risk aversion
oeÆ ient = 0:03 and initial apital u = 0.
The state premiums are known from example 1.

OPC number P1 P2 P3
1 1.022 5.108 24.318
2 1.118 5.701 23.168
3 1.145 5.206 23.908
4 1.917 5.709 21.520
We will now evaluate how OPC1, OPC2, OPC3 and OPC4 are do-
ing in relation of having equal risk quantity (RQ), equal ruin proba-
bility (RP), equal expe ted utility (EU) and maximal expe ted utility
(MEU). This is done in the following way. Let RQij denote the risk
quantity in state j if Pj is determined from OPCi. We then introdu e
the variable RQi to denote how well OPCi is doing in relation of having
equal risk quantities, let RQi be given by
P3
RQi = P4 jP =1 pj jRQ1j RQij j :
3
i=1 ( j =1 pj jRQ1j RQij j)
The numerator denotes how far the RQ is from the optimal RQ (the
RQ obtained by OPC1) weighted by the state probabilities. The de-
nominator is in luded in order to normalize the expression su h that
it an be ompared with the three other ases. Note that RQi is 0 for
i = 1.
A orresponding formula is used to al ulate the variables that de-
notes how well the OPCi's are doing in relation of having equal ruin
probabilities (the RPi 's) and equal expe ted utilities (the EUi 's). For
the maximal expe ted utility we use the following formula
MEUi = P4
jMEU4 MEUij
i=1 (jMEU4 MEUi j)
In the table below we have listed RQi , RPi , EUi and MEUi for
i=1,2,3 and 4.
OPC number RQ RP EU MEU
1 0 0.300 0.113 0.468 0.881
2 0.144 0 0.220 0.190 0.554
3 0.105 0.195 0 0.342 0.643
4 0.751 0.504 0.667 0 1.922
In the olumn to the right the sum of the gures are listed. From
this olumn we an now rank the OPC's. It is seen that OPC2 is
the best OPC to use for the agent onsidered in this example. But
it is important to note that the analysis is highly depended on the
preferen es of the agent. If we set the risk aversion oeÆ ient dierent
we might obtain another ranking, e.g. if we set = 0:04 we will, based

on table 1, expe t OPC4 to do better.
7. The in omplete market ase
In this se tion we onsider the in omplete market ase, i.e. we now
onsider a market where the number of states n is larger than the
number of se urities. Let now k denote the number of se urities. Let
again vi be the pri e of state se urity number i and let v = (v1 ; : : : ; vk ).
7.1. The unrestri ted premium ase. Be ause of the in omplete-
ness in this market we are no longer able to onstru t the n AD se u-
rities. We therefore annot onstru t the optimal trading strategy and
set the premium by P = q1 P1 + + qn Pn . So instead of onstru t-
ing the optimal trading strategy an alternative ould be to hoose the
heapest strategy whi h assures that the premium in state i is greater
than or equal to Pi = E [Li ℄ + Æi for all states, i.e. hoose a trading
strategy that solve the following problem
min
m
vm
k
X
st mj ij E [Li ℄ + Æi i = 2; : : : ; n:
j =1
A problem of this strategy is that it ould be very expensive. An
alternative strategy is therefore to hoose the premiums so that they get
as lose as possible to the optimal premiums (P1 ; : : : ; Pn), i.e. hoose
the portfolio m that solves the following problem
n X
X k
min
m1 ;::: ;mk
( mj ij Pi )2
i=1 j =1
or equivalent
2
P1 3
min
m
kCm 4 ... 5 k2
Pn
where C now is a n k matrix. This is a well known problem and it is
solved by the least square solution whi h is given by, (see [1℄ p. 318),
2
P1 3
m = (C T C ) 1 C T 4 ... 5
Pn
After these onsiderations we now make the following denition
Denition 7.1. A least square strategy is a trading strategy su h
that the insuran e ompany gets as lose as possible to the desired n
state premiums as possible in the least square sense, i.e. the least
square strategy is obtained by the following portfolio of se urities.
2
P1 3
m = (C T C ) 1 C T 4 ... 5
Pn
The insuran e ompany would of ourse prefer to follow the optimal
trading strategy given by Pi = E [Li ℄ + Æi but this is impossible in this
market. But if it has been possible the insuran e ompany would have
been willing to pay more for the optimal strategy than for the least
square strategy. Therefore if the insuran e ompany follows the least
square strategy they should harge a premium that is larger than the
pri e of the least square strategy. They thereby get a ompensation for
not having the optimal strategy but only the least square strategy.
7.2. The restri ted premium ase. Let us now as in the omplete
ase onsider the situation where the insuran e ompany is unable to
harge the desired premium be ause of some ompetitive reasons. We
again set the possible xed premium that an be harged to P0 .
The problem now is that we want to set the Pi 's a ording to OPC1,
OPC2, OPC3 or OPC4 but the equation P0 = P1 q1 + + Pn qn is no
longer valid. We are no longer able to onstru t the n AD se urities
in this in omplete market. But instead of hoosing the Pi s a ording
to OPC1, OPC2, OPC3 or OPC4 we ould hoose the orresponding
least square solution. We then just have to repla e the equation P0 =
P1 q1 + + Pn qn with an equation that makes sure that the pri e of the
least square portfolio is equal to P0 . Before we solve this problem we
make the following denition in relation to OPC1, OPC2 and OPC3.
We return to OPC4 later.
Denition 7.2. The in omplete optimal premium hoi e (IOPC)
is dened as a hoi e of premiums (Pi 's) su h that
The Pi's solve the n 1 rst equations in OPC1, OPC2 or OPC3.
The pri e of the least square strategy orresponding to the Pi's is
P0 .
The IOPC is then found by the following theorem
Theorem 7.3. The solution to the IOPC orresponding to OPC1,
OPC2 or OPC3 is found by solving the n equations with n unknowns
from the OPC. But where the last equation in OPC1, OPC2 and OPC3
is repla ed by
2
P1 3
P0 = q~ 4 ... 5 = q~1 P1 + + q~n Pn
Pn
where q~ is given by
q~ = v (C T C ) 1 C T
Proof. The least square strategy orresponding to (P1 ; : : : ; Pn ) is given
by
2
P1 3
m = (C T C ) 1 C T 4 ... 5
Pn
and the pri e of the state se urities is given by v = (v1 ; : : : ; vk ). The
pri e of the least square strategy orresponding to (P1 ; : : : ; Pn) is then
given by
2
P1 3
vm = v (C T C ) 1 C T 4 ... 5
Pn
2 3
P1
= q~ ... 5 = q~1 P1 + + q~n Pn
4 (7.4)
Pn
where q~ is given by
q~ = v (C T C ) 1 C T
It then follows by denition 7.2 that if the last equation in OPC1,
OPC2 or OPC3 is repla ed by 7.4, we will obtain the orresponding
IOPC.
For OPC4 the situation is dierent. OPC4 is a maximization prob-
lem and we therefore just have to reformulate the problem to a problem
of dimension k instead of a problem of dimension n. The IOPC for
OPC4 therefore takes the following form
max
m
E [v (u + i m Li )℄
st vm = P0 :
The maximization problem is solved in the same way as des ribed in
se tion 5.
8. Con lusion
In this paper we have been looking at risk with more than one prior
estimate of the frequen y. As mentioned in the introdu tion it is not
possible to hedge this kind of risk using traditional insuran e pra ti e
only, so a new method was alled for. In this paper we present a
model that is able to manage this kind of risk. The model works by
using traditional insuran e pra ti e and trading in the se urity market
simultaneously. The paper shows how this new method works both in
omplete and in omplete markets.
Further we onsider the ase where the premium the insuran e om-
pany an harge is restri ted. In this ase the insuran e ompany has
to hoose an allo ation of the restri ted premium orresponding to the
states of the world. We propose four dierent methods of solving this
problem. These four methods are then analysed and evaluated and by
examples advantages and disadvantages are illustrated. We also show
a way to rank the four methods in the ase where we onsider an agent
that evaluates the four OPC equally and has a known utility fun tion.
Referen es
1. Beauregard, R.A. and Fraleigh, J.B. (1990), Linear Algebra, 2nd Edition,
Addison-Wesley Publishing Company.
2. Chi hilnisky, G. and Heal, G. (1998), Managing Unknown Risks, The future of
global reinsuran e, The Journal of Portfolio Management, pp 85-91, summer
1998.
3. Henderson, J.M. and Quandt, R.E. (1980) Mi roe onomi Theory, A Mathe-
mati al Approa h, M Graw-Hill book ompany.
Aarhus C, Denmark

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SECURITIZATION OF INSURANCE RISK

CLAUS VORM CHRISTENSEN

Paper I: Pri ing atastrophe insuran e produ ts based on a tually

Paper II: The PCS option, an improvement of the CAT-future,

Paper IV: Implied loss distributions for atastrophe insuran e

Paper V: How to hedge unknown risk, 23 pages.

Summaries of Manus ripts in the Thesis (English)

Refereed Publi ations

estimating volatilities and al ulate onsistent pri es using, say the

Summaries of Manus ripts in the Thesis (Danish)

de tidligere artikler. Vi benytter en metode, som ogs a er kendt fra

\Hvordan man afdkker ukendt risiko", (Manuskript, Aarhus Uni-

vlge en allokering af den begrnsede prmie hrende til de forskel-

2. The differen e between finan ial and a tuarial

initial apital u. Then the apital of the ompany after year i is

v 00 < 0. The premium  for the insuran e ompany an be de ned

and the premium to be harged at time t = 0

For a given nite time horizon [0; T ℄ we onsider a ompany holding

viable premium prin iples have the following properties (formulated in

Q( ) =  EEP P[Y[exp(

So, in a suÆ iently liquid insuran e market, lassi al insuran e pre-

3. Se uritization, the CAT-future

Date Event loss

3.1. Des ription of the CAT-future. CAT-futures are traded at

INTERIM REPORT FINAL SETTLEMENT

Figure 3.1. June CAT-Future ontra t

at ertain times and laims being reported immediately. In su h a

laim number distribution by a negative binomial distribution; more

Nt^T1 Mi (T2 ) NT1 i (T2 )

i.e. the nal aggregate amount LT an at time t be represented as a

the parameter to depend on the information from the laims having

to al ulate F~L (; t). In [17℄ we nd an approximation to the expression

4. Se uritization, the PCS-option

4.1. Des ription of the PCS-option. In this se tion the de nitions

1 When a ompany, at time t and at a pri e Ft , enters a short position of a future

onstru tion using options instead of futures and \options on futures",

The idea of Gerber and Shiu [43℄ is to hoose h = h su h that

Motivated by this, we will use the following model for Pt

= e r(T t) E [E [C (T2 ; LT )jFT ℄jFt ℄

the value of E [C (T2 ; LT )jFT ℄ is given by (4.10). At time t < T1

Model 3. The next model will also rely on a light-tail distribution

If the approximation should be good we will also need the Var(Yij )

Figure 5.1. The values.

will be too omputationally heavy. We return to this dis ussion later.

should be invariable, sin e it ould be a problem to nd a solution if

Call-Spreads Kl =KU bid ask

Model par. 1 par. 2 par. 3 par. 4 value

Kl =KU bid M1 M2 M3 M4 M5 M6 ask

A detailed dis ussion of these results an be found in [19℄. We now

Kl =KU bid LM CVC ask

In relation to how the parameters should be estimated we nd that an

Theorem 6.1. An optimal trading strategy an be obtained if and only

These observations allow us to reformulate the problem to a problem

6.4. The in omplete market ase. In this se tion we onsider the

A problem of this strategy is that it ould be very expensive. An

the portfolio m that solves the following problem

In relation to how the parameters should be estimated we have ome

[59℄ Sondermann, D. (1988): Reinsuran e in arbitrage-free markets. Insuran e:

Paper II: The PCS-option, an improvement of the CAT-future,

Paper IV: Implied loss distributions for atastrophe insuran e

Paper V: How to hedge unknown risk, 23 pages.

CLAUS VORM CHRISTENSEN AND HANSPETER SCHMIDLI

de tidligere artikler. Vi benytter en metode, som ogs a er kendt fra

\Hvordan man afdkker ukendt risiko", (Manuskript, Aarhus Uni-

vlge en allokering af den begrnsede prmie hrende til de forskel-

v 00 < 0. The premium for the insuran e ompany an be dened

Q() = EEP P[Y[exp(

4.1. Des ription of the PCS-option. In this se tion the denitions

Mi is mixed Poisson distributed with mixing distribution F. That

For i Nt , given i , Si is then ompound Poisson distributed with

rameter Ni=TNt +1 i (FD (T2 i )). So all in all we get that LT Lt =

S1 + + SNt + SNt +1 + + SNT given NT ; 1 ; : : : ; NT ; 1 ; : : : ; NT

where ~i are iid uniformly distributed on (t; T1 ) and independent of

provided t < T1 , and EQ [Y ℄ = m0Y ()=mY (). If T1 t T2 we nd

distribution of i given Ft . It would be desirable if the prior and the

FtC FtU AE AE(G) AE(E)

21608.8 and for = 0:05 and = 3 10 7 the apped future pri e is

resurveys PCS Identied Catastrophes that, based upon its Prelimi-

points, Safe-Pla e is ompensated for the dieren e between the lower

Ft is the smallest right ontinuous omplete ltration, su h that

= L0 exp(1 T1 ) exp(~2 (t T1 )(e +~ 1))

= L0 exp(1 T1 ) exp(2 (t T1 )):

Finally we will ompute P (Xt x)

) e (1+hd) +(1+hd ) e hd +hd = r + 2

dene 2+1 = 2 te (hd +1) +(hd +1) and +1 = 2 (hd + 1) + .