Industry Loss Warranties
Encyclopedia
Industry Loss Warranties, often referred to as ILWs, are a type of reinsurance or derivative contract through which one party will purchase protection based on the total loss arising from an event to the entire insurance industry rather than their own losses. For example, the buyer of a "$100mm limit US Wind ILW attaching at $20bn" will pay a premium to a protection writer (generally a reinsurer but sometimes a hedge fund
) and in return will receive $100mm if total losses to the insurance industry from a single US hurricane exceed $20bn. The industry loss ($20bn in this case) is often referred to as the "trigger." The amount of protection offered by the contract ($100mm in this case) is referred to as the "limit." ILWs could also be constructed based on an index not linked to insurance industry losses. For example, Professor Lawrence A. Cunningham of George Washington University suggests adapting similar mechanisms to the risks that large auditing firms face in cases asserting massive securities law damages.
These agreements are usually documented as reinsurance
contracts between the parties. If so, in addition to the industry loss trigger the contract will include an "ultimate net loss clause" which specifies that the protection buyer must demonstrate that they have lost a specified amount as well.
ILWs are sometimes referred to as Original Loss Warranties (OLWs) or Original Market Loss Warranties, but this usage is becoming increasingly rare.
. The entry of many hedge funds into the market (for which ILWs are a preferred trading vehicle) along with the breakdown of the retrocessional reinsurance market (reinsurance for reinsurers) led to the growth of the ILW market.
The ILW market has no recognized exchange or clearing source to track volumes. Size estimates range from $2bn to $10bn outstanding (Aon, Nephila). The pre-Katrina market in terms of outstanding contracts was likely near the low end of that range and the post Katrina market is likely to have moved upward within that range.
(ISO), is generally the source for industry loss estimates for US perils. SIGMA, a division of Swiss Re
, is often the source for such losses outside the US, with Munich Re
's NatCAT Service appearing more and more often on ex-US business.
was $20bn US Wind and Quake. A number of other US Wind and Quake zones as well as Japanese Quake and European windstorm
and various second event coverages also trade in the market.
Many catastrophe bond
s are triggered by industry-based triggers and trade with reference to pricing in the ILW markets.
These contracts are often negotiated directly between parties. In addition, brokers including Willis
and Access Re publish estimated bid and offer levels and attempt to arrange trades. Catastrophe bond traders including Swiss Re
and Goldman Sachs
have indicated their intention to trade these instruments.
Dead Cat contracts are traded on an event that had already occurred, but for which the total amount of industry loss is not yet known. Some market participants refer to contracts against perils which are out of season (for example, hurricane contracts outside of hurricane season) as dead cats.
Back-up Covers provide protection for events that occur following the occurrence of a catastrophe.
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
) and in return will receive $100mm if total losses to the insurance industry from a single US hurricane exceed $20bn. The industry loss ($20bn in this case) is often referred to as the "trigger." The amount of protection offered by the contract ($100mm in this case) is referred to as the "limit." ILWs could also be constructed based on an index not linked to insurance industry losses. For example, Professor Lawrence A. Cunningham of George Washington University suggests adapting similar mechanisms to the risks that large auditing firms face in cases asserting massive securities law damages.
These agreements are usually documented as reinsurance
Reinsurance
Reinsurance is insurance that is purchased by an insurance company from another insurance company as a means of risk management...
contracts between the parties. If so, in addition to the industry loss trigger the contract will include an "ultimate net loss clause" which specifies that the protection buyer must demonstrate that they have lost a specified amount as well.
ILWs are sometimes referred to as Original Loss Warranties (OLWs) or Original Market Loss Warranties, but this usage is becoming increasingly rare.
Development of the ILW Market
The first contracts of this type were traded in the 1980s. This market remained fairly small (though influential in price setting for reinsurance as these contracts are more consistent than most reinsurance treaties) through Hurricane KatrinaHurricane Katrina
Hurricane Katrina of the 2005 Atlantic hurricane season was a powerful Atlantic hurricane. It is the costliest natural disaster, as well as one of the five deadliest hurricanes, in the history of the United States. Among recorded Atlantic hurricanes, it was the sixth strongest overall...
. The entry of many hedge funds into the market (for which ILWs are a preferred trading vehicle) along with the breakdown of the retrocessional reinsurance market (reinsurance for reinsurers) led to the growth of the ILW market.
The ILW market has no recognized exchange or clearing source to track volumes. Size estimates range from $2bn to $10bn outstanding (Aon, Nephila). The pre-Katrina market in terms of outstanding contracts was likely near the low end of that range and the post Katrina market is likely to have moved upward within that range.
Loss Measurement in ILWs
Property Claims Services, a division of the Insurance Services OfficeInsurance Services Office
Insurance Services Office, Inc. , a subsidiary of Verisk Analytics, is a provider of data, underwriting, risk management and legal/regulatory services to property-casualty insurers and other clients...
(ISO), is generally the source for industry loss estimates for US perils. SIGMA, a division of Swiss Re
Swiss Re
Swiss Reinsurance Company Ltd , generally known as Swiss Re, is a Swiss reinsurance company. It is the world’s second-largest reinsurer, after having acquired GE Insurance Solutions. The company has its headquarters in Zurich...
, is often the source for such losses outside the US, with Munich Re
Munich Re
Munich Re Group is a reinsurance company based in Munich, Germany. It is one of the world’s leading reinsurers. ERGO, a Munich Re subsidiary, is the Group’s primary insurance arm....
's NatCAT Service appearing more and more often on ex-US business.
Common ILW Contracts and Market Dynamics
The benchmark contract for the market for a number of years around Hurricane KatrinaHurricane Katrina
Hurricane Katrina of the 2005 Atlantic hurricane season was a powerful Atlantic hurricane. It is the costliest natural disaster, as well as one of the five deadliest hurricanes, in the history of the United States. Among recorded Atlantic hurricanes, it was the sixth strongest overall...
was $20bn US Wind and Quake. A number of other US Wind and Quake zones as well as Japanese Quake and European windstorm
European windstorm
A European windstorm is a severe cyclonic windstorm associated with areas of low atmospheric pressure that track across the North Atlantic towards northwestern Europe. They are most common in the winter months...
and various second event coverages also trade in the market.
Many catastrophe bond
Catastrophe bond
Catastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors...
s are triggered by industry-based triggers and trade with reference to pricing in the ILW markets.
These contracts are often negotiated directly between parties. In addition, brokers including Willis
Willis Group Holdings
Willis Group Holdings is a global insurance broker headquartered in the Willis Building, London, United Kingdom. It has more than 400 offices in 120 countries, and approximately 17,000 employees...
and Access Re publish estimated bid and offer levels and attempt to arrange trades. Catastrophe bond traders including Swiss Re
Swiss Re
Swiss Reinsurance Company Ltd , generally known as Swiss Re, is a Swiss reinsurance company. It is the world’s second-largest reinsurer, after having acquired GE Insurance Solutions. The company has its headquarters in Zurich...
and Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
have indicated their intention to trade these instruments.
Specific Types of ILWs
Live Cat contracts are ILW contracts traded while an event is in progress—usually a hurricane approaching land.Dead Cat contracts are traded on an event that had already occurred, but for which the total amount of industry loss is not yet known. Some market participants refer to contracts against perils which are out of season (for example, hurricane contracts outside of hurricane season) as dead cats.
Back-up Covers provide protection for events that occur following the occurrence of a catastrophe.
See also
- Alternative Risk TransferAlternative Risk TransferAlternative Risk Transfer is the use of techniques other than traditional insurance and reinsurance to provide risk bearing entities with coverage or protection...
- ReinsuranceReinsuranceReinsurance is insurance that is purchased by an insurance company from another insurance company as a means of risk management...
- Catastrophe bondCatastrophe bondCatastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors...
- Reinsurance sidecarReinsurance SidecarReinsurance sidecars, conventionally referred to as "Sidecars," are financial structures that are created to allow investors to take on the risk and return of a group of insurance policies written by an insurer or reinsurer and earn the risk and return that arises from that business...
- International Society of Catastrophe ManagersInternational Society of Catastrophe ManagersThe International Society of Catastrophe Managers is a professional association that promotes catastrophe management professionalism within the insurance industry.-Goal and objectives:...
External links
- Access Reinsurance Inc
- Guy Carpenter ILW blog
- Conference on Insurance- and Risk-Linked Securities (the Bond Markets Association)
- On the Basis Risk of Industry Loss Warranties (2000 article by Lixin Zeng)
- Financial Innovation (article by EnsureEgypt)
- Hedging Catastrophe Risk Using Index-Based Reinsurance Instruments, Casualty Actuarial Society Forum, Vol. Spring, 245-268 (2003 by Lixin Zeng)
- International Society of Catastrophe Managers
- Reinsurance Guru - reinsurance news and analysis Web-site
- Industry Loss Warranties coverage from Artemis.bm