What is Industry Loss Warranty
An industry loss warranty is an insurance or reinsurance contract in which coverage is triggered when the losses experienced by an industry exceed a specific threshold. Industry loss warranties (ILW) are most commonly written by reinsurance companies or hedge funds, since these organizations are able to absorb more losses than smaller insurance companies.
BREAKING DOWN 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 that it has experienced a loss. This is because the coverage trigger is not based off of the experience of the insured and is instead based on losses over a wide number of organizations. The trigger can also be linked to an index other than industry losses, such as the magnitude of an earthquake or the wind speed of a storm.
Insurance companies may specialize in a particular line of coverage, and may underwrite policies in a limited geographic area. For example, an insurance company may write property insurance policies across the state of Florida. In most cases, the frequency and severity of claims is limited to small geographic areas, such as when a lake floods and damages a few homes. With catastrophes, however, the number of properties damaged and the extent of the damage can escalate quickly, potentially pushing the insurer into insolvency. To protect themselves from catastrophes, insurers may purchase an industry loss warranty.
For example, consider an insurer who underwrites property insurance policies across a state that is occasionally hit by hurricanes. Because hurricanes may damage the properties of a large proportion of its 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 from wind damage. If more than $10 billion in losses are reported from a hurricane, the insurer will receive $125 million.
History of The Industry Loss Warranty
The first industry loss warranty contracts were traded in the 1980s. The market was fairly small (though influential in price setting for reinsurance as these contracts are more consistent than most reinsurance treaties) through Hurricane Katrina. However, a rush of hedge funds entering 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 $2 billion to $10 billion. 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.