Catastrophe swap
A contract in which two risk carriers exchange weakly correlated catastrophe exposures, or in which one pays a fixed stream against a payment contingent on an event, to diversify without raising capital.
A Japanese insurer heavily exposed to Tokyo-area earthquakes and a US insurer heavily exposed to Florida hurricanes each hold a concentrated portfolio. Each would gain from holding a share of the other's risk, which has almost no chance of occurring in the same year. A catastrophe swap organizes this exchange without a portfolio transfer or a securities issue: each party commits to pay the other if its event occurs, according to a trigger defined in advance, loss index, physical parameter or modeled loss. Another form, closer to financial products, has one party pay a fixed stream, comparable to a premium, against a payment contingent on a catastrophe. Swaps are documented on derivatives market templates, which makes them quick to conclude but exposes them to counterparty risk, unless collateralized. Their value is to allow geographic diversification for players with neither a sales network nor a license in the other country. Their limit lies in basis risk and accounting and prudential treatment: if they do not transfer genuine insurance risk, they may be treated as derivatives rather than reinsurance.
Hypothetical case: two insurers swap 100 million dollars of risk: one pays if a magnitude 7.5 earthquake hits the Tokyo region, the other if a category 4 hurricane makes landfall in Florida. Neither has to raise capital, and each lowers its capital requirement through diversification.
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