What Are Catastrophe Futures?

Catastrophe futures, or cat futures, are derivatives contracts traded on the Chicago Board of Trade (CBOT). They are used primarily by insurance companies to protect themselves against future catastrophic losses. The value of a catastrophe futures contract is typically equal to $25,000 multiplied by the catastrophe ratio, which is a numerical value provided by the CBOT every quarter.

Key Takeaways

  • Catastrophe, or cat, futures are derivative contracts used by insurance companies to hedge against a catastrophic loss.
  • These contracts trade on the CBOT and arose as an alternative to the traditional reinsurance market.
  • Payoffs are based on potential catastrophe losses as predicted by a catastrophe loss index determined by the CBOT.

Understanding Catastrophe Futures

Catastrophe futures started trading on the Chicago Board of Trading (CBOT) in 1992. The value of 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.

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.

How Catastrophe Futures Work

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 CBOT, is then employed to obtain the actual payoff of the contract.

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.