Catastrophe Futures and Options (Finance)

Catastrophe futures and options are derivative securities whose payoffs depend on insurers’ underwriting losses arising from natural catastrophes (e.g. hurricanes). Specifically, the payoffs are derived from an underwriting lo ss ratio that measures the extent of the US insurance industry’s catastrophe losses relative to premiums earned for policies in some geographical region over a specified time period. The loss ratio is multiplied by a notional principal amount to obtain the dollar payoff for the contract. The Chicago Board of Trade (CBOT) introduced national and regional catastrophe insurance futures contracts and the corresponding options on futures in 1992.

Insurers/reinsurers can use catastrophe futures and options to hedge underwriting risk engendered by catastrophes (see Harrington et al., 1995) For example, when taking a long position, an insurer implicitly agrees to buy the loss ratio index at a price equal to the current futures price. Accordingly, a trader taking a long catastrophe futures position when the futures price is 10 percent commits to paying 1 0 percent of the notional principal in exchange for the contract’s settlement price. If the futures loss ratio equals 15 percent of the notional principal there is a 5 percent profit. Conversely, if the settlement price is 5 percent at expiration, the trader pays 10 percent and receives 5 percent of the notional principal for a 5 percent loss. The CBOT catastrophe futures contracts have a notional principal of US$25,000.


Prior to the expiry of the contract, the futures price reflects the market’s expectation of the futures loss ratio. As catastrophes occur or conditions change so as to make their occurrence more likely (e.g. a shift in regional weather patterns), the futures price will increase. Conversely, if expected underwriting losses fro m catastrophes decrease, the futures price will decrease. Given that the futures price reflect s the futures loss ratio’s expected value, an insurer can take a long futures position when a contract begins to trade at a relatively low futures price. Then, if an unusual level of cata strophe losses occur, the settlement price will rise above the established futures price and the insurer will profit on the futures position and thus offset its higher than normal catastrophe losses.

Call and put options on catastrophe futures contracts are also available. A futures call (put) option allows the owner to assume a long (short) position in a futures contact with a futures price equal to the option’s exercise price. For example, consider a call option with an exercise price of 40 percent. If the futures price rises above 40 percent, the call option can be exercised which establishes a long futures position with an embedded futures price of 40 percent. If the futures price is less than 40 percent at expiration, the call option will expire worthless.

Catastrophe futures and options are an innovative way for insurers to hedge underwriting risk arising from catastrophes. In essence, the catastrophe derivatives market is a secondary market competing with the reinsurance market for trading underwriting risk.

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