Department of Finance, School of Economics and Management, Tsinghua University, 386G Weilun Building, Beijing 100084, China.
Risk Finance for Catastrophe Losses with Pareto-Calibrated Lévy-Stable Severities
Article first published online: 18 OCT 2012
© 2012 Society for Risk Analysis
Volume 32, Issue 11, pages 1967–1977, November 2012
How to Cite
Powers, M. R., Powers, T. Y. and Gao, S. (2012), Risk Finance for Catastrophe Losses with Pareto-Calibrated Lévy-Stable Severities. Risk Analysis, 32: 1967–1977. doi: 10.1111/j.1539-6924.2012.01906.x
- Issue published online: 16 NOV 2012
- Article first published online: 18 OCT 2012
- catastrophe losses;
- Lévy-stable distribution;
- Pareto distribution;
- risk finance;
For catastrophe losses, the conventional risk finance paradigm of enterprise risk management identifies transfer, as opposed to pooling or avoidance, as the preferred solution. However, this analysis does not necessarily account for differences between light- and heavy-tailed characteristics of loss portfolios. Of particular concern are the decreasing benefits of diversification (through pooling) as the tails of severity distributions become heavier. In the present article, we study a loss portfolio characterized by nonstochastic frequency and a class of Lévy-stable severity distributions calibrated to match the parameters of the Pareto II distribution. We then propose a conservative risk finance paradigm that can be used to prepare the firm for worst-case scenarios with regard to both (1) the firm's intrinsic sensitivity to risk and (2) the heaviness of the severity's tail.