Catastrophe Futures

What Are Catastrophe Futures?

Catastrophe futures, or cat futures, are derivatives contracts first traded on the Chicago Board of Trade (CBOT) to hedge against catastrophic losses. They are used primarily by insurance companies to protect themselves against prospective claims due to some disaster that could cause financial ruin for the insurer.

In 2007, the Chicago Mercantile Exchange (CME) acquired the CBOT and announced that catastrophe futures would continue trading through its NYMEX division. These contracts are indexed to the CME hurricane index (CHI), but their prices and trading information are available only to subscribers or data purchasers.

The value of a catastrophe futures contract when launched was initially $25,000 multiplied by the catastrophe ratio, which was a numerical value provided by the exchange every quarter.

Understanding Catastrophe Futures

Also known as catastrophe risk futures, these contracts started trading on the CBOT in 1992 in the aftermath of Hurricane Andrew. The value of catastrophe futures contracts increases when the prospects of catastrophic losses are high and decrease when the chances of such losses are low.

Catastrophe futures utilize an underwriting loss ratio that estimates the potential of catastrophe losses borne by the American insurance industry for policies written that cover a particular geographical region over a specified period of time. The loss ratio, computed by the exchange, is then employed to obtain the actual payoff of the contract.

In the event of a catastrophe, if losses are high, the value of the contract goes up and the insurer makes a gain that hopefully offsets whatever losses might be incurred. The reverse is also true. If catastrophe losses are lower than expected, the value of the contract decreases, and the insurer (buyer) loses money.

Property owners, especially those in catastrophe-prone areas, are faced with the unavailability of insurance coverage as well as an increased deductible level, restricted coverage, and increased prices when coverage is available. Insurance companies are faced with increased demand from insureds, regulatory restrictions on price increases, and increasing retention levels and prices associated with decreasing reinsurance capacity.

Reinsurers, once able to retrocede risk to other reinsurers, are now accepting business from ceding companies under extremely limited terms. Governments, as regulators of the insurance markets, must play a role in administering the estates of companies rendered insolvent by catastrophes and organizing governmental or quasi-governmental facilities providing primary insurance or reinsurance capacity.

Benefits of Catastrophe Futures

A catastrophe futures contract helps protect insurance companies in the wake of a significant natural disaster when numerous policyholders file claims within a short time frame. This type of event places substantial financial pressure on insurance companies.

A catastrophe future allows insurance companies to transfer some of the risks they've assumed through policy issuance and provides an alternative to purchasing reinsurance or issuing a catastrophe bond (CAT). A CAT is a high-yield debt instrument, usually insurance-linked, and meant to raise funds in case of a catastrophe such as a hurricane or an earthquake. However, some catastrophe swaps include the use of a catastrophe bond.

In some cases, insurers trade futures from different regions of a country. The trading of policies allows insurers to diversify their portfolios. For instance, a trade between an insurer in Florida or South Carolina and one in Washington or Oregon could mitigate significant damage from a single hurricane.