What Is a Catastrophe Swap?

A catastrophe swap is a customizable financial instrument traded in the over-the-counter derivatives market. A catastrophe swap enables insurers to guard against massive potential losses resulting from a major natural disaster, such as a hurricane or earthquake. Insurers can transfer some of the risks they've assumed through policy issuance and provide an alternative to purchasing reinsurance or issuing a catastrophe bond (CAT), a high-yield debt instrument.

Key Takeaways:

  • A catastrophe swap is a customizable instrument that protects insurers from massive potential losses resulting from a major natural disaster, such as a hurricane or earthquake.
  • Insurers can transfer some of the risks they've assumed without having to purchase reinsurance or issuing a catastrophe bond.
  • For some catastrophe insurance swaps, insurers trade policies from different regions of a country, allowing them to diversify their portfolios.

Understanding Catastrophe Swap

In finance, a swap is a contractual agreement between two parties to exchange cash flows for a given period. For a catastrophe swap, two partiesan insurer and an investorexchange streams of periodic payments. The insurer's payments are based on a portfolio of the investor's securities, and the investor's payments are based on potential catastrophe losses as predicted by a catastrophe loss index.

A catastrophe swap 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 swap is a way for insurance companies to transfer some of the risks they've assumed rather than purchasing reinsurance or issuing a catastrophe bond (CAT).

A CAT is a high-yield debt instrument, usually insurance-linked, designed 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 catastrophe insurance swaps, insurers trade policies from different regions of a country. The trading of policies allows insurers to diversify their portfolios. For instance, a swap between an insurer in Florida or South Carolina and one in Washington or Oregon could mitigate significant damage from a single hurricane.

Example of a Catastrophe Swap

In 2014, as part of its Capital-At-Risk notes program, which allows its clients to hedge against natural disaster risk, the World Bank issued a three-year, $30 million catastrophe bond. The catastrophe bond linked to the risk of damage by earthquake and tropical cyclones in 16 countries within the Caribbean was part of a catastrophe swap with the Caribbean Catastrophic Risk Insurance Facility (CCRIF).

Simultaneous to the issuance of the $30 million bond, the World Bank entered an agreement with the CCRIF, which echoed the terms of the bond. The World Bank's balance sheets held the proceeds from the bond. If a natural disaster occurred, the principal of the bond would have been reduced by an agreed-upon amount laid out under the terms, and the proceeds would then have been paid to the CCRIF.