Catastrophe Swap

What Is a Catastrophe Swap?

A catastrophe swap is a customizable financial instrument traded in the over-the-counter (OTC) derivatives market that enables insurers to guard against massive potential losses resulting from a major natural disaster, such as a hurricane or earthquake. These instruments enable insurers to 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.

Understanding a 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 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 (CLI).

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 CAT—a high-yield debt instrument, usually insurance-linked, designed to raise funds in case of a catastrophe, such as a hurricane or an earthquake.

In some catastrophe insurance swaps, insurers trade policies from different regions of a country. The goal here is 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, the World Bank issued a three-year, $30 million catastrophe bond as part of its Capital-At-Risk notes program, which allows its clients to hedge against natural disaster risk. The catastrophe bond, linked to the risk of damage by earthquakes 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.