ORIGINAL ARTICLE BY IRANYA JOSEPH

 

Understanding Industry Loss Warranties (ILW’s)

Just like Catastrophe Bonds, Industry Loss Warranties are also a form of an insurance linked Security. However, Unlike CAT Bonds which sprouted to life in the Mid-1990’s, Industry Loss warranties-abbreviated as ILW’s have been in use since the early 1980’s and are sometimes also referred to as Original Loss Warranties.

In this article, we shall be looking at what industry loss warranties are, key features and how they operate.

What is an Industry Loss Warranty?

An Industry loss warranty is simply a derivative or reinsurance contract that pays the reinsured for losses arising from a catastrophic event on the basis that the resulting industry losses exceed a pre-determined limit. The Industry Losses act as the trigger that facilitate payment to the cedant.

An ILW can for example be structured to pay out if the Total Industry Losses from a Catastrophic Event like an Earthquake exceed US$ 5bn. In this case the US$5bn is the trigger. If the Total Industry Losses are less than that, then no payment will be made.

The Industry Loss Warranties take on two primary forms i.e. (1) The Binary ILW and (2) The Indemnity-Based ILW. We shall look at these two forms in detail further below. Much as the foundation of the industry loss warranty is built on the basis of the industry losses, the credibility of the measurement of the amount of losses from a catastrophic event is very important. Particular Indices are thus used to this effect. The Index frequently used is to measure industry loss is the Property Claims Service (PCS) in the United States. However, other indices also used to calculate industry loss data include; Sigma-Swiss Re, NatCatSERVICE-Munich Re, and PERILS.

Some of the Key Features of an Industry Loss Warranty:

Some of the key characteristics of the industry loss warranty include the following;

Warranty/Industry Loss Limit: This is the monetary value of the Industry Loss that would trigger payment from the ILW. You could think of a warranty as some form of industry deductible. For example, the warranty for an earthquake could be $10 bn.

Reporting Period: The Period from the date of loss within which the reinsured has to notify the ILW contract. The Reporting period could range from 24-36 Month. During this period, the cedant would be able to determine if the total industry losses meet the industry loss limit specified to be able to trigger payment.

Retention: Is the amount of loss, which the reinsured will retain in addition to the Industry Loss Limit before a recovery can be made from the ILW Contract. If the warranty in an ILW contract is $1 million and the Retention is $100,000. Then payment can only be triggered if the losses exceed $1.1 million.

Limit: This is the amount of coverage that the cedant is purchasing. Also called the coverage limit.

Term: This is the duration of the reinsurance contract. The period, for which the ILW will run for, within which losses will be covered. It is usually 12 month.

Territory: This is the geographical area within which the losses should occur for the trigger to be activated.

Premium: The Premium payable for the contract is expressed as a rate on line of the cover limit sought.

An example of an Industry Loss Warranty (Hypothetical – excerpt McDonnell 2002) is shown below.

  • Territory: 50 States in the United States
  • Term: 01/01/2017 – 31/12/2017
  • Limit: US$ 5,000,000
  • Retention: US$ 100,000
  • Warranty: US$ 15,000,000,000
  • Index: Property Claims Service (PCS)
  • Perils Covered: All Natural Perils
  • Rate on Line: 20%
  • Premium: Payable in full at inception
  • Reporting Period: 36 month from the date of Loss

There are basically two types of Industry Loss Warranties. These are (a) The Binary Industry Loss Warranty and (2) Indemnity Based Industry Loss Warranty.

The Binary Industry Loss Warranty is type of contract which will pay a fixed sum if the total industry loss from a catastrophic event exceeds a pre-determined limit (attachment point). Let us Consider the example 1 below to demonstrate how this works.

Example 1: ABC Insurance company purchases an Industry Loss Warranty for protection against Catastrophe losses with the following details. Territorial Scope: East Africa. The Limit of Cover is 5,000,000. The Period is 12 Months from 01 January. Index used is the Property Claims Service. Perils Covered Earthquake, Reporting Period is 24 Months from the date of loss. Warranty is 1Bn.

The ILW purchased by ABC will cover property losses in the East Africa Region resulting from an Earthquake. Should an Earthquake occur within the 12-month period from 01 January and the total property losses in the region hit 1Bn and above, then under the Binary arrangement, the contract will pay a fixed sum of the cover limit of 5,000,000. If the total industry loss from that region were say 700,000,000, ABC has a reporting period of up to 24 Months from the date of loss for the Property Claims Services to provide the final industry loss estimate. Should the final Loss still not exceed the 1Bn trigger limit, then ABC will not recover anything from the contract. If it does exceed, the ABC would recover the 5,000,000.

It is important to note that since the contract specified the index as the PCS, then it will only consider the data provided by the PCS. If Sigma for example provided a loss figure of 1Bn while that provided by the PCS states the industry loss at 900,000,000, then the contract wouldn’t pay out.

The Indemnity Based Industry Loss warranty- on the other hand will pay a fixed sum if total industry loss exceeds the pre-determined limit as well as the company retention. In other words, two triggers have to be satisfied for a pay-out to be activated i.e. the industry loss trigger and the company’s retained loss trigger. Let’s consider Example 2 Below;

Example 2: ABC Insurance company purchases an Industry Loss Warranty for protection against Catastrophe losses with the following details. Territorial Scope: East Africa. The Limit of Cover is 5,000,000 and the Retention is 20,000. The Period is 12 Months from 01 January, Index used is the Property Claims Service. Perils Covered Earthquake, Reporting Period is 24 Months from the date of loss. Warranty is 1Bn

Scenario A: If During the Period, ABC suffers losses to its property portfolio of up to 20,000,000. And Total Industry Losses stand at 850,000,000. In such a scenario, ABC wouldn’t be able to recover anything from the contract because the trigger limit hasn’t been met.

Scenario B: During the 12 Month Period, ABC Suffers losses to its property portfolio of up to 20,000,000. And Total Industry losses hit a record 2Bn. ABC would be able to recover from the contract since the conditions for payout have been met. The total industry loss is greater than the trigger limit (2Bn>1Bn). The absolute trigger limit of (1Bn + 20,000) has also been satisfied.

The two forms of Industry Loss Warranties i.e the Binary and the Indemnity can further be structured as an occurrence ILW or an Aggregate ILW.

A Per Occurrence ILW; – This type of Industry Loss warranty pays out to the cedant for losses resulting from a single catastrophic event. It can for example pay out for losses from a single Earthquake or Single Hurricane.

An aggregate ILW on the other hand pays out if (1) each individual cat loss exceeds the warranty and also the aggregate sum of all the cat losses within that specified period exceed a pre-agreed aggregate retention. You may have 3 or 4 hurricanes hitting a particular region each with differing levels of damage. If the sum of all the losses from these hurricanes exceed the industry loss limit specified in the contract, then the contract will make a pay-out

An aggregate retention limit will be stated in the contract. If for example, the warranty specifies a 1Bn, All Individual Catastrophe Losses for whom the total industry loss is less than the 1Bn warranty will not be included in calculation of the aggregate losses at the end of the period. For example, If the aggregate retention was 4Bn. And 5 earthquakes were occurred each with industry losses of 500mn, 1Bn, 1.1Bn, 2Bn and 950Mn. In the calculation of the aggregate loss, the industry loss of 500Mn and 950Mn will not be included since they are less than the warranty. The aggregate loss amount will therefore be 1Bn + 1.1 Bn+ 2Bn = 4.1Bn. Since this is greater than the aggregate retention of 4Bn, the pay out from the bond will be activated.

The Warranty could also specify coverage for losses below 500mn, In such a case all losses above 500mn will not be included in the calculation of the aggregate retention.

Premium:

The premium charged for cover under an ILW is expressed as a rate on line of the coverage limit. For example, if ABC insurance company purchases a 2BN Earthquake ILW with a 18.0% rate on line and a coverage limit for of 10million, then the Premium Charged will be 18.0%*10,000,000 = 1,800,000

Using statistical Models, the rate on line is determined for a given trigger limit and cover limit.

Why Consider Industry Loss Warranties?

In comparison with other forms of Insurance Linked Securities, the Industry Loss warranties are easier to structure and less complex. They are also cheaper compared to both Traditional Reinsurance Methods and other Alternative Methods of Risk Transfer. Since ILW’s are not designed to directly protect the portfolio of the cedant, the cedant is not required to disclose information regarding its portfolio to the party selling the cover and as such Moral Hazard is more or less eliminated.

Basis Risk?

ILW’s are dependent on an index of industry losses, managing Basis Risk is therefore a primary point of concern to the cedant/the party purchasing the cover. As such it is vital that an appropriate trigger level is estimated such that the variation between the actual losses suffered by the reinsured and the pay-off is very minimal.

 

Additional Sources of Information

  • McDonnel, E. (2002): Industry Loss Warranties, Access Re
  • Gazert, N. et.al (2007): An Analysis of pricing & Basic Risk for Industry Loss Warranties, University of St. Gallen, Switzerland
  • Blanchet, J.H. et al (2017): Mitigating Extreme Risk Through Securitization, Society of Actuaries
  • Cummins, J.D. (2008): Cat Bonds & Other Risk-Linked Securities; State of the Market and Recent Developments, Risk Management and Insurance Review, Vol.11, No.1, 23-47

 

 

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Hedging Catastrophe Risk Using Industry Loss Warranties

Editor’s Note: In this article, Michael Wedel, Manager in AIR’s Consulting and Client Services Group, discusses how industry loss warranties are used to hedge catastrophe risk—as well as how AIR’s CATRADER® software can be used to evaluate hedge effectiveness.