What Is an Industry Loss Warranty (ILW)?
An industry loss warranty (ILW) is a reinsurance or derivative contract that pays out when the financial losses experienced by an industry exceed a specified threshold. Also known as original loss warranties, the contracts are often written by hedge funds or reinsurance companies, which are more able to absorb significant losses compared with smaller insurers.
- An industry loss warranty (ILW) is a reinsurance or derivative contract that kicks in when losses experienced by an industry exceed a specified threshold.
- Coverage is typically triggered when an index provider says the relevant threshold has been met.
- Usually, an insured party's own losses don't have a bearing on whether it receives a payout, though there are exceptions.
- Industry loss warranty contracts are often annual and can even be bought during and after a catastrophic event.
- They are commonly written by reinsurance companies or hedge funds.
How an Industry Loss Warranty (ILW) Works
Industry loss warranties compensate companies—usually insurers—when a catastrophic event severely and broadly impacts their industry. In return for paying a premium, the insured party will receive a payout should industry-wide damages surpass a pre-determined threshold.
Insurers may specialize in a particular line of coverage and underwrite policies in a limited geography. A company might write property insurance policies in Florida, for example. In most cases, the frequency and severity of claims is limited to a small area, such as when a lake floods and damages a few homes.
With catastrophes, however, the number of properties damaged and the extent of damage can escalate quickly, potentially pushing the insurer into insolvency. To protect against catastrophes, insurers may purchase an industry loss warranty.
Coverage in an industry loss warranty is typically triggered by a third party reporting that an event has occurred, rather than by the insured indicating it has experienced a loss. This third party might be an index tasked with measuring industry loss. Common examples include the Property Claims Service in the United States or SIGMA, a division of Swiss Re.
ILWs sometimes contain thresholds that must be met to claim compensation, such as the insured party experiencing a specified amount of loss.
Example of an Industry Loss Warranty (ILW)
Consider an insurer that underwrites property insurance policies across a state that is occasionally hit by hurricanes. Because hurricanes may damage large swathes of a geographic area and impact a large number of policyholders simultaneously, the insurer purchases an industry loss warranty with a $125 million coverage limit that is triggered when more than $10 billion in losses are reported. What this means is that if more than $10 billion in losses are reported from a hurricane, the insurer will receive $125 million.
Types of Industry Loss Warranties (ILWs)
Industry loss warranty contracts are typically annual and can even be bought during and after a catastrophic event unfolds.
For example, there are live cat contracts, which are tradable while an event is occurring; dead cat contracts, which can be bought after the event happened provided that the total amount of industry loss is not yet known; and back-up covers, which offer protection against follow-up events stemming from catastrophes, such as fires or floods.
Criticism of Industry Loss Warranties (ILWs)
Like most forms of insurance, industry loss warranties aren't free of controversy. One particular area of scrutiny is the trigger specified in the contract and its relationship with the nominated indices responsible for indicating whether it's been met.
In the past, there have cases where the agreed trigger and the index chosen to represent it haven't properly aligned. That could be due to something as simple as the index monitoring a different region of the world, not tracking certain events covered in the contract, or two indices being used that produce vastly different and conflicting loss estimates.
The decade the first industry loss warranty (ILW) contracts were traded.
History of the Industry Loss Warranty (ILW)
The first industry loss warranty contracts traded in the 1980s and were fairly low profile. The market remained small until a rush of hedge funds entered the fray and the retrocessional reinsurance market (reinsurance for reinsurers) broke down.
While the industry loss warranty market has no recognized exchange or clearing source to track volumes, it was estimated to be worth about $5.5 billion to $6 billion in January 2019.