Optimal Liquidity and Risk Management: The Use of CAT Bonds

This article develops a model to study the utilization of catastrophe (CAT) bonds in liquidity and risk management for an insurance company. We consider an insurer who can manage its risk exposure through reinsurance and CAT bonds with index triggers. In addition, the insurer determines a dividend policy to maximize shareholder value; that is, the expected discounted dividends until ruin. We solve the mixed regular-singular stochastic control problem and derive the optimal strategies. We find that, unless significant basis risk is present, the use of CAT bonds generally advances dividend payments, expands insurers’ capacity, and adds substantial value to shareholders. Moreover, the insurer’s ability to expand capacity is crucial for leveraging the benefits of CAT bonds.