Catastrophe Swap

What Is a Catastrophe Swap?

A catastrophe swap is an adjustable financial instrument traded in the over-the-counter (OTC) derivatives market that empowers insurers to prepare for enormous potential losses coming about because of a major natural disaster, like a hurricane or quake. These instruments empower insurers to transfer a portion of the risks they've assumed through policy issuance and give an alternative to purchasing reinsurance or giving 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 a financial backer — exchange surges of periodic payments. The insurer's payments depend on a portfolio of the financial backer's securities, and the financial backer's payments depend on potential catastrophe losses as anticipated by a catastrophe loss index (CLI).

A catastrophe swap safeguards insurance companies in the wake of a huge natural disaster when various policyholders file claims inside a short time period. This type of event puts significant financial pressure on insurance companies.

A catastrophe swap is a way for insurance companies to transfer a portion of the risks they've assumed, rather than purchasing reinsurance or giving a CAT — a high-yield debt instrument, as a rule insurance-linked, intended to bring funds up in case of a catastrophe, like a hurricane or a tremor.

Some catastrophe swaps incorporate the utilization of a catastrophe bond.

In some catastrophe insurance swaps, insurers trade policies from various districts of a country. The goal here is to diversify their portfolios. For example, a swap between an insurer in Florida or South Carolina and one in Washington or Oregon could moderate huge damage from a single hurricane.

Illustration 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 permits its clients to hedge against natural disaster risk. The catastrophe bond, linked to the risk of damage by quakes and typhoons in 16 countries inside the Caribbean, was part of a catastrophe swap with the Caribbean Catastrophic Risk Insurance Facility (CCRIF).

Concurrent to the issuance of the $30 million bond, the World Bank entered an agreement with the CCRIF, which repeated the terms of the bond. The World Bank's balance sheets held the proceeds from the bond. In the event that a natural disaster happened, the principal of the bond would have been decreased by a settled upon amount spread out under the terms, and the proceeds would then have been paid to the CCRIF.

Highlights

• A catastrophe swap is a way for insurance companies to transfer a portion of the risks they've assumed, rather than purchasing reinsurance or giving a catastrophe bond (CAT).
• For some catastrophe insurance swaps, insurers trade policies from various districts of a country, permitting them to differentiate their portfolios.
• A catastrophe swap is an adjustable instrument that safeguards insurers from enormous potential losses coming about because of a major natural disaster, like a hurricane or seismic tremor.