Mitigating Flood Risk with CAT bonds: A New Orleans Case Study

Floods cause billions of dollars in losses each year and involve different natural disasters like hurricanes, mudslides, and prolonged rainfall. Data from the Federal Emergency Management Agency (FEMA) indicates that flood losses in the U.S. have increased in severity and frequency over the years, stemming from climate change and a greater number of extreme weather events. This paper presents a case study of how catastrophe (CAT) bonds can be used to manage the financial risk of flooding in Orleans Parish, an area with high exposure to flooding, according to data retrieved from FEMA.

We present a multi-period model for the valuation of a CAT bond with an industry trigger, that aims to provide coverage for extreme flood losses. This valuation method incorporates a Generalized Extreme Value (GEV) distribution to model flood losses. The price of the CAT bond is obtained through Monte Carlo simulations with stochastic interest and discount rates. Different pay-out structures and assumptions are tested, to show the sensitivity of the CAT bond’s price to the coverage provided and the model parameters, respectively.

Find the Q&A here: Q&A on 'Managing Emerging Risks'