What is 'Cat Spread'

A cat spread is a type of derivative traded on the Chicago Board of Trade (CBOT) that takes the form of an option on a catastrophe futures contract. In other words, a cat spread is basically a call option spread bought by insurance companies on catastrophe futures contracts. Purchasing a cat spread involves buying or selling a call option whose underlying asset is a catastrophe contract, while simultaneously selling or buying the same number of call options at a higher strike price. A cat spread is used by insurance companies to hedge risk coverage of catastrophic events.

BREAKING DOWN 'Cat Spread'

Consider an insurance company that buys a cat spread on a catastrophe futures contract with an expectation that the loss ratio on catastrophic events will fall within the range of 20 to 40 percent. If losses fall within that range, the insurance company would exercise the option and sell the contract, enabling the company to make a profit which will be used to offset the losses. However, if the loss ratio does not fall within the 20 to 40 percent range, the option will expire at zero and the only thing the company has to lose is the original investment.

Cat Spreads and Insurance Catastrophe Futures

Insurance catastrophe futures contracts began trading on December 11, 1992, on the Chicago Board of Trade (CBOT). A key objective is to increase liquidity of a market by bringing in new participants. These new participants, who are not consumers or producers of a commodity, increase liquidity of a market with their shorter term investment time horizon. For insurance catastrophe futures, the attraction of capital from non-traditional sources for insurance risk can create increased catastrophe capacity that is needed in today’s insurance market.

In traditional insurance or reinsurance, the process of insuring against catastrophes is tedious requiring months of negotiations to conclude a sound agreement, In addition, the reversal of such agreements through commutation negotiations is equally tedious. Through the design of uniform insurance agreements, the CBOT attempts to develop a liquid market in which catastrophe risks can be easily assumed or transferred and in which non-traditional capital is attracted to insurance.

In addition, unlike reinsurance, hedging through options has the advantage of reversibility; any position may be closed before the maturity of the futures or option contract if the overall exposure of the insurer has diminished. Although reinsurance is technically reversible, in practice, reversing a reinsurance transaction exposes the insurer to relatively high transaction costs, as well as additional charges to protect the reinsurer against adverse selection.

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