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What is Industry Loss Warranty?
Industry Loss Warranty or ILW is a derivative instrument primarily used by insurers to hedge their risks in the world of alternate risk transfer (other than traditional risk transfer of insurance/reinsurance). Originally offered by Reinsurers for Aviation and Marine insurance markets, currently, Reinsurers and Hedge funds offer these contracts for almost all catastrophic risks covers
Why is it required?
Any insurer in its desire to protect the risks it has provided cover for needs large capital. The traditional method of approaching the reinsurance market to spread the risk has been practiced however there has been a concern of hardening price cycles in the reinsurance market driven by capacity and rising insured loss quantum from catastrophic events. For these reasons, an obvious choice that remains is to tap into the capital markets to access capital. There are several instruments collectively treated as Insurance-Linked Securities (ILS) that help insurers access this avenue and amongst that is the ILW. ILW market is often termed as a fast-growing market with outstanding amounts on the contracts ranging up to $87 billion.
How does it work?
The ILW contract is between the insurer and the issuer (Reinsurer or Hedge Fund, ILS fund houses, Lloyd’s syndicates). The contract takes a parametric trigger, such as a threshold breach of a loss index (e.g. total loss to the overall insurance industry from a catastrophic event), and identifies the payout based on the limit for each contract. There may be additional conditions in the contract such as the insurer itself having a minimum loss experience threshold which is more common. Once these conditions are satisfied, the contract pays out automatically.
There are more recent developments where the ILW contracts are being traded in a marketplace where the buyer (seeking capacity), brokers, and sellers (providing capacity) come together and can trade the contracts at price determined automatically by the exchange. Brokers earn the commission and any additional associated fee. With an efficient clearing mechanism in place, the demand for such trades has started to see an uptick.
Types of Industry Loss Warranty (ILW)
US Wind and Earthquake is the category that has seen good activity in the ILW market. An insurer who has exposure to hurricanes in Florida could buy a Live Cat ILW contract (when the hurricane is already occurring) or could buy a Dead Cat ILW contract (when the hurricane has ended) and protect its exposure up to the contract limit. There are contracts for follow-on events that are generally predicted to happen after a large hurricane or earthquake. These contracts are designed to cover follow-on events after a catastrophe even when they are different events (e.g. Fire after earthquake, Flooding after hurricane).
Primary indices to identify the payout trigger for such ILS contracts are Property Claim Services (PCS) in the US, Perils (Perils ILW Index service) in Europe, Sigma/Munich Re Cat Service.
References:
- https://www.investopedia.com/terms/i/industry-loss-warranty.asp
- https://www.prweb.com/releases/tremor_successfully_clears_worlds_first_programmatic_ilw_trade/prweb17051458.htm
- https://www.artemis.bm/library/what-are-industry-loss-warranties-ilws/
- https://www.investopedia.com/terms/i/industry-loss-warranty.asp
