What is 'Catastrophe Futures'
Catastrophe futures are futures contracts traded on the Chicago Board of Trade (CBOT). These futures contracts are used by insurance companies to protect themselves against future catastrophe losses. The value of a catastophe futures contract is equal to $25,000 multiplied by the catastrophe ratio for the quarter. The catastrophe ratio is a numerical value provided by the CBOT every quarter.
BREAKING DOWN 'Catastrophe Futures'
Catastrophe futures started trading on the Chicago Board of Trading (CBOT) in 1992. The value of a catastrophe future contracts increase when catastrophe losses are high and decrease when catastrophe losses are low. 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 that 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.
Why Catastrophe Futures Were Needed
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 administering the estates of companies rendered insolvent by catastrophes and organizing governmental or quasi-governmental facilities providing primary insurance or reinsurance capacity.
How Catastrophe Futures Work
Catastrophe future payoffs are derived from an underwriting loss ratio that measures the extent of the US insurance industry's catastrophe losses, relative to premiums earned for policies in some geographical region over a specified time period. The loss ratio is multiplied by a notional principal amount to obtain the dollar payoff for the contract.
Insurers and reinsurers use catastrophe futures (and options) to hedge underwriting risks posed by catastrophes. For example, when taking a long position, an insurer implicitly agrees to buy the loss ratio index at a price equal to the current futures price. Accordingly, a trader taking a long catastrophe futures position when the futures price is 10 percent commits to paying 10 percent of the notional principal in exchange for the contract's settlement price. If the futures loss ratio equals 15 percent of the notional principal, there is a 5 percent profit. Conversely, if the settlement price is 5 percent at expiration, the trader pays 10 percent and receives 5 percent of the notional principal.