Optimal control under uncertainty: Application to the issue of CAT bonds

TL;DR

This paper develops a framework for optimally issuing catastrophe bonds considering uncertain natural disaster parameters, using Bayesian updates and numerical solutions to a quasi-variational equation, with applications to hurricanes in Florida.

Contribution

It introduces a novel approach combining Bayesian updating with optimal control for CAT bonds under parameter uncertainty, solved via a quasi-variational PDE.

Findings

Framework effectively models disaster arrival uncertainty.

Numerical solutions enable practical policy determination.

Application to hurricanes demonstrates real-world relevance.

Abstract

We propose a general framework for studying optimal issue of CAT bonds in the presence of uncertainty on the parameters. In particular, the intensity of arrival of natural disasters is inhomogeneous and may depend on unknown parameters. Given a prior on the distribution of the unknown parameters, we explain how it should evolve according to the classical Bayes rule. Taking these progressive prior-adjustments into account, we characterize the optimal policy through a quasi-variational parabolic equation, which can be solved numerically. We provide examples of application in the context of hurricanes in Florida.