Catastrophe Risk and the Implied Volatility Smile

Property-casualty insurers are exposed to rare but severe natural disasters. This article analyzes the relation between catastrophe risk and the implied volatility smile of insurance stock options. We find that the slope is significantly steeper compared to the rest of the economy and exhibits a seasonal pattern due to hurricanes. We are able to link the insurance-specific tail risk component derived from options with the risk spread from catastrophe bonds and global economic losses caused by catastrophes. Our results provide an accurate, high-frequency calculation for catastrophe risk linking the traditional derivatives market with insurance-linked securities.