HURRICANE RISK MANAGEMENT WITH CLIMATE AND CO2 INDICES

We propose a regime-switching Poisson process incorporating climate and carbon dioxide (CO2) indices (RPCM) to model hurricane frequency. Model accuracy shows that two-state RPCM (2-RPCM) is superior to the existing climate methods, as forecast errors under 2-RPCM are smaller than previous models by about 60–75 percent. We derive the pricing formula of reinsurance premiums by assuming the aggregate loss following the regime-switching compound process. Pricing errors under 2-RPCM for reinsurance premiums are 35–54 percent lower than those from previous models. The climate and regime-switching effects dominate the CO2 effect in reducing pricing errors and producing more effective tail value at risk. © 2016 The Journal of Risk and Insurance