CAT Risk Model, CAT-Bond & AI Twisted DFA

CAT issues: Big players today give the impression that they release details but in fact they don’t say anything on CAT modeling. The audience only gets the message that the “sellers" have some tool that is useful. CATs are difficult to handle. CAT-Bond is impossible to handle. High impact with low probability is the reason. Risk transfer is a must but for society as whole it might remain irrelevant. There is a difference between 1 million impact with probability one in a million and one billion impact with a probability of one over 10 billion. When it falls on your head, the first is a big loss, the second is a certain ruin and a burden for society for the next hundred years. (billion = European billion = 10^{12})

CAT bonds: what is a Catastrophe? The instrument (e.g. a bond) deals with an event that needs very precise description. We remember the one event — two event discussion after 9/11. Sometimes it will be difficult to distinguish between man made and natural, for instance when a dam collapses after extreme rainfall. As risk analysts we can only hope that the lawyers did their best. Before selling the bond (as an example) there must be a very detailed discussion between the legal advisers and the risk analysts.

Can a CAT help? as an insurer one must set a clear (see one event, two events) limit to the outstanding. In most cases the claims can be covered by the premia. On top comes the CAT-bond. This bond must remain attractive for the investor and that means that huge capital is involved. What can you (insurer) do with this money? Same question when interest rates are low or negative? Invest it in the stock market my cause big influences because of the amounts involved. Also it adds financial risk to an already complicated instrument. Very very high expertise is needed.

DFA or Dynamic Financial Analysis is a big name for putting together cash stream (+ or -) over different time intervals. It is not — as far as I know — a well defined procedure. Any tool that puts together these cash streams (with or without risk correction) can be called DFA. Some procedures are easy (too easy and too simple) and took over the meaning of the word. Here you must mention what is different and better than the procedures used by the competition. Dynamic risk measures play a BIG role.

Whatever people say about old fashioned tools: in the future you are faced to + and - cash streams, probability related amounts (with probabilities that are well defined or where you just have a guess). You must take decisions and must try to minimise damage in whatever sense. The only way to do that is to describe these inputs (including your risk tolerance and the risk tolerance of society = regulation). Then you can see what you can do with all these numbers, giving names is not solving the problem.

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