Cat Spread

It sounds like you ordered the wrong appetizer at that weird new restaurant around the corner. But no...this has to do with finance.

We all like "simple," and insurers are no exception. Often, gauging loss and how to handle that loss involves an insurer and a reinsurer, and negotiations, and complicated estimates, and more intense negotations. You get the idea.

So, in 1992, the CBOT Chicago Board of Trade started trading these contracts after recognizing the need for insurers to protect themselves in a new way against loss. Prior to 1992, the insurance company pretty much had to try to keep enough in reserves to cover their best-guess loss total, or just shift the cost to the member. If you watch the news, you’ll know deductibles are still an issue in 2018, but we digress, Often, insurance companies just didn’t sell policies to people who lived in areas with a lot of natural disasters.

Futures contracts are an agreement to buy a security at a set rate at a specified time in the future. The spread here is the difference between the asking bid price and the selling price. Insurance companies report their losses and premiums quarterly. Those amounts form an index for that specific region.

It works like this: the insurer buys a catastrophic futures contract. The losses exceed the premiums, the loss/premium ratio works in their favor, and they make money. It makes it easier to absorb the losses. When they’re low, the insurer might actually lose money. The contracts are designed to cushion the blow in the event of bigger-than-expected losses. They are an insurance policy for the insurance company, if you will. And we're sure you will.