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Answer: An inevitable feature of catastrophic risk is that the loss events are highly dependent on each other; the loss events are not independent and usually they are not even nearly independent
**Correct answer: D** - CAT bonds can be used as an alternative to **reinsurance**, because the proceeds or principal may help meet catastrophe-related claims. - They usually have **low correlation with financial markets**, which makes them attractive for diversification. - A major drawback is **basis risk**: the payout depends on how the triggering catastrophe is defined. - The false statement is **D** because catastrophic events are not inherently highly dependent on each other; they are generally treated as separate, low-correlation events rather than being "not independent" in the way described.
Author: Manit Arora
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Q-703.3. Catastrophe (CAT) bonds are a popular derivative instrument for hedging catastrophic risk. A CAT bond pays a higher-than-normal interest rate and is often issued by a subsidiary of an insurance company. Each of the following is TRUE about the features of a CAT bond EXCEPT which is false?
A
For an insurance company, issuing CAT bonds is an alternative to reinsurance: the interest or principal can be used to meet claims
B
CAT bonds tend to have little or no correlation to market returns such that their total risk can be diversified away in a large portfolio
C
A drawback of CAT bonds is the covered loss depends on a definition of "catastrophic loss" which is inevitably subjective and qualitative so that the issuer's basis risk is high
D
An inevitable feature of catastrophic risk is that the loss events are highly dependent on each other; the loss events are not independent and usually they are not even nearly independent
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