This paper assumes that the underlying aggregate catastrophe claims process is the compound Poisson process and applies the recursive evaluation approach to compute the compound Poisson distribution. A novel, practical pricing model is developed for catastro-phe insurance derivatives. The proposed pricing model simplifies the procedure of prob-ability computation, particularly for massive catastrophe claims, and helps hedging in-surance companies apply probability assessment techniques to identify derivative prices. The recursive evaluation approach to price catastrophe derivatives is more effective than the conventional Monte Carlo simulation scheme in terms of the required computing time and precision.

Insurance futures and options have been trading on the Chicago Board of Trade since December, 1992. This paper describes these derivative instruments, explains how they have changed over time, illustrates trading volume and price levels, discusses the safety of the financial guarantees backing these contracts, analyzes trends in catastrophe losses, summarizes the literature relating to insurance derivatives and briefly describes some additional capital market securities that attempt to deal with catastrophe risk. We suggest that if derivatives were widely used to cope with catastrophe risk, then a disaster the magnitude of Hurricane Andrew would have severely stressed the financial markets, possibly leading to significant defaults. If the insurance industry is not successful in coping with catastrophe risk in some manner, either through insurance derivatives or other means, then more drastic steps, as outlined in this paper, will have to be taken to cope with this risk to avoid widespread insurer insolvency when a devastating catastrophe next occurs.

A model for the PCS index is introduced and it is shown how to price a PCS option. It is discussed how to approximate option prices.