A cat spread is a type of derivative traded on the Chicago Board of Trade that takes the form of an option on a catastrophe futures contract. In other words, a cat spread is basically a call option spread bought by insurance companies on catastrophe futures contracts. Purchasing a cat spread involves buying or selling a call option whose underlying asset is a catastrophe contract, while simultaneously selling or buying the same number of call options at a higher strike price. A cat spread is used by insurance companies to hedge risk coverage of catastrophic events.
|||Let’s say an insurance company buys a cat spread on a catastrophe futures contract with an expectation that the loss ratio on catastrophic events will fall within the range of 20% to 40%. If losses fall within that range, the insurance company would exercise the option and sell the contract, enabling the company to make a profit which will be used to offset the losses. However, if the loss ratio does not fall within the 20% to 40% range, the option will expire at zero and the only thing the company has to lose is the original investment.