What is a Catastrophe Swap
A catastrophe swap is a customizable financial instrument traded in the over-the-counter derivatives market which enables insurers to guard against massive potential losses resulting from a major natural disaster such as a hurricane or earthquake. In a catastrophe swap, two parties, an insurer, and an investor, exchange 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.
BREAKING DOWN Catastrophe Swap
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 an event places substantial financial pressure on insurance companies. A catastrophe swap 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 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, connected 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.
Simultaneous to the issuance of the $30 million bond, the World Bank entered an agreement with the Caribbean Catastrophe Risk Insurance Facility (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’ve been reduced by an agreed-upon amount laid out under the terms, and the proceeds would then have been paid to the CCRIF.