Minimization of Trigger Error in Cat-in-a-Box Parametric Earthquake Catastrophe Bonds with an Application to Costa Rica

Abstract

Catastrophe bonds are used by the insurance and reinsurance industry and by national governments to cede catastrophic risks to the financial markets. Triggers whose outcomes depend only on the earthquake parameter data published by respected third parties can be implemented to determine without moral hazard whether the bond principal is paid for a certain event. Sensitivity analyses to different design assumptions show that these transactions are often affected by trigger error, unless a sufficiently dense geographic discretization is selected to define the trigger zones. A process of general application to any geography is developed to minimize the trigger error. The methodology is illustrated with the design of a hypothetical cat bond for Costa Rica.