Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 6. Catastrophe and Risk

ERIK BANKS

Managing Director, Risk Advisory, Unicredit Group Europe

Abstract: Low-frequency/high-severity catastrophe events impacting companies operating in vulnerable areas have the potential of creating very large economic losses and must be managed through a rigorous risk management process. Development of a proper risk framework requires an understanding of both frequency and severity of natural and man-made catastrophes. Companies can examine frequencies by determining recurrence intervals, occurrence frequencies, and nonencounter probabilities (which together help indicate whether a catastrophe is likely to be nonrepetitive, irregular, regular, or seasonal), and they can estimate economic severity by coupling the potential magnitude of a disaster with direct and indirect losses and secondary costs. These event loss results can then be used to create a suitable risk management plan.

Keywords: financial risk, operating risk, pure risk, speculative risk, catastrophe risk, event loss, frequency, severity, occurrence frequency, recurrence interval, nonencounter probability, nonrepetitive catastrophe, irregular catastrophe, regular catastrophe, seasonal catastrophe, vulnerability, direct loss, indirect loss, secondary costs, risk management framework

Risk, which we define as the uncertainty surrounding the outcome of an event, is an integral and inevitable part of business. Companies and governments operating in the complex economic environment of the ...