Hot cat contracts: industry loss warranties are growing in popularity as insurers look to balance their risks and fill in gaps in traditional catastrophe coverage.

Key Points

* Industry loss warranties are a creative risk management tool for insurers looking to balance their portfolios.

* Demand for industry loss warranties has increased 35% since Hurricane Katrina.

* Pricing for industry loss warranties also has increased.

The successful use, speed and ease of industry loss warranties have made them hot reinsurance products in the current post-Hurricane Katrina market. The number of contracts has grown by as much as 35%, according to broker John B. Collins Associates Inc. Meanwhile, the pricing of industry loss warranties also has increased, making the market tempting for sellers, including both traditional reinsurers and hedge funds.

"It's a good alternative to traditional capacity," said Stefano Nicolini of Collins. "These contracts are very transparent; there are no surprises. You get a check when the cover has been triggered. For Katrina, buyers wrote a letter to their broker and seller saying, '[Property Claim Services] reported the industry loss that had triggered the cover. Here's my company's loss.' And in a week or less, the check had arrived. It's a very straightforward transaction."

Fast and Creative

There are three basic ways primary insurers can obtain catastrophe protection: purchase traditional catastrophe reinsurance, issue catastrophe bonds or purchase an industry loss warranty.

For traditional reinsurance, a reinsurer examines the primary writer's book of business and underwriting, and then negotiates price and limits. It can be a complicated, lengthy process, but it is the bulk of all reinsurance contracts.

Unlike traditional catastrophe reinsurance, industry loss warranties are based on two triggers: a specific loss to the industry as a whole, plus a specific loss to the buyer. However, the buyer's underlying book of business--and underwriting--is not a factor. That makes the contracts relatively easy and fast to write.

"The big difference [between traditional cat reinsurance and ILWs] is the second trigger and the way it's priced," Nicolini said. "Traditional reinsurance is priced based on the portfolio of the company. ILWs are priced on the probability of an event to happen and cause a certain amount of losses to the industry."

Industry loss warranties are similar to catastrophe bonds in that they have a physical trigger--say a Category 3 hurricane striking the U.S. East Coast, or an earthquake in California. They are triggered when a catastrophe causes a predetermined amount of losses to both the total industry and the buyer. The contracts often rely on the industry loss as defined by ISO's Property Claim Services unit or another industry scorekeeper. Sellers can basically establish one price and one basic contract and sell it to anyone who wants to buy it.

Industry loss warranties "are quicker to do than a cat bond," said Al Selius, managing director of Swiss Re's Capital Management and Advisory. "But cat bonds have a lot more liquidity. You can sell them if you need to. ILWs are negotiated contracts, but they are very short. Most are for a year, and most investors don't mind the illiquidity for a year."

Unlike cat bonds, industry loss warranties are not traded as a security per se. However, some companies have bought and sold ILWs at different trigger points to hedge their risk.

For instance, the same company might sell an industry loss warranty that would be triggered with a $40 billion industry loss, hut buy one for protection on a $50 billion industry loss.

"It's a way to balance risk," Selius said. "If they've written too much California earthquake risk, they can go out and buy some coverage in the ILW market."

Who Sells ILWs

Hedge funds had become active in the ILW market before the busy 2005 hurricane season. The product was originally developed in the retrocessional market in the late 1980s during a capacity shortage. Since then, primary insurers have also used industry loss warranties as a source of catastrophe reinsurance capacity. Some ILWs were triggered by the terrorist attacks of Sept. 11,2001, and by the European storms of Lothar and Martin in 1999, Nicolini said. However, Hurricane Katrina is the first big test of the hedge funds' involvement in the market.

Even after many industry loss warranties were triggered by Katrina, the hedge funds were not scared off by losses and have written even more business, Nicolini said.

"After Katrina, we've seen a lot of people look into this cover, both selling and buying it," Nicolini said. He estimated pricing had gone up 35% to 100% in some areas.

Selius of Swiss Re estimated pricing had increased by 30% to 60% in some areas, including U.S. windstorm coverage.

"Modeling firms are changing their models for frequency and vulnerability, and saying we're in a cycle in the next 10 years where there's going to be a lot more storms. The risks are greater than they had been in the past," Selius said.

So there's been a rush on some reinsurers to get more capital, and many reinsurers have used ILWs to get additional capacity and to take on additional risk, Selius said. "It's an expensive market for reinsurers, but that's why hedge funds like it."

Hedge funds remain the new entrants into the industry loss warranty market, which is still dominated by the large reinsurers, Selius said.

It's hard to get a handle on the size of the ILW market. Selius estimated it to be about $5 billion to $8 billion in total insured value. Stated another way, Nicolini estimated it might have a total of $500 million in premiums.

Since Katrina, sellers aren't interested in industry loss triggers below $20 billion, whereas there were many writing at industry triggers of $10 billion before.

One of the strengths of ILWs is their flexibility. They can be written to cover very broad territories--say the entire United States--or just a single state. They can be written to offer coverage for as short as two to three days to a month, a year or longer. The ease and speed of putting the contracts in place are a boon to insurers looking to hedge risk even during a "live cat" event or when a potential catastrophe is approaching.

"That's the beauty of an ILW for a live cat," said Jonathan J.R. Dodd, chief financial officer of Quanta Capital Holdings, which received a $3 million payment from an ILW triggered by Hurricane Rita. "There can be a hurricane barreling toward Florida two days away, and you can still buy an ILW 10 minutes before the storm hits. Of course, the closer the storm is to making landfall, the more expensive it gets. It's a real-time risk management tool and is very efficient."

The live-cat industry loss warranty might have just a two- or three-day term.

ILWs are often designed to reinstate, so if an event triggers the policy, a client will pay another premium to reinstate the cover two or even three more times.

"The benefit to you is you've reinstated your protection. The benefit to the insurer is they've recovered extra premium to help recover from the loss of the first event," Dodd said.

Covering Gaps

Industry loss warranties aren't designed to replace traditional catastrophe reinsurance, which is still the foundation of risk transfer for the insurance industry. An ILW is more likely to fill in gaps in coverage, or come into play at higher layers of reinsurance coverage.

"It's a complement to reinsurance; it's not going to replace reinsurance," Selius said.

For instance, the annual reinsurance contract of a Collins client was nearing expiration, and it was clear renewal negotiations would extend beyond the expiration date. While the negotiations were still under way, the client recognized the only exposure it would have for the first month of the new contract was for California earthquake. Collins then brokered a one-month ILW for California earthquake to bridge the gap.

"You can be very creative with these contracts," Nicolini said. "You can tailor it any way you want. As long as the models come up with the probabilities, you can sell the product."

For instance, Nicolini said one client was interested in purchasing an industry loss warranty to cover the third hurricane of a Category 3 or higher that makes landfall in the United States in 12 months or 24 months. This would protect the company from the frequency of events.

ILWs can be done for multiple perils or single perils. They've also been written for earthquake in Japan, and Caribbean and European wind risks.

Poised for Growth

While the industry loss warranty market has been around for years, it was still fairly quiet until about two years ago, said Selius of Swiss Re.

"Five years ago, it wasn't growing very much at all. There have been years when it was shrinking. But in the last two years, there's been tremendous growth. It's a combination of the hard market and the number of hedge funds seeking new ways to take insurance risk," Selius said.

Following the surge since Katrina, demand is poised to continue to grow, Nicolini said.

"Given the size and volatility of market losses over the last couple of years, I'd expect more activity, particularly in the offshore energy and property market as insurers seek efficient sources of protection linked to industry data, rather than relying solely on internal models which may have been unable to cope with unusually severe events," Dodd of Quanta said.

What's an Industry Loss Warranty?

An industry loss warranty (ILW) is a reinsurance contract in which the payout is dependent on two triggers. The first trigger is the insured loss of the buyer, the indemnity; the second trigger is the loss to the underlying insurance industry as a whole, the original insured industry loss. Both triggers have to be hit for the buyer of the ILW to receive a claims payout. Although the second trigger usually dominates, the first trigger is preserved to ensure that the buyer gets reinsurance accounting treatment. The first trigger distinguishes ILWs from pure derivatives. ILWs are also known as original loss warranties (OLWs) and market loss warranties (MLWs). ILWs are primarily used to protect against property risk, property catastrophe, marine, aviation, satellite losses, terrorism and workers' compensation catastrophe.

Source: Alternative Risk Strategies, Edited by Morton Lane

Characteristics of industry loss warranties include:

* TERRITORY: Can range from being as narrow as a single state to as broad as an entire country or region.

* PERILS: Can range from all natural perils to individual perils of earthquake, hurricane, tornado or terrorism only.

* REPORTING PERIOD: Usually 36 months, although can be triggered as soon as the industry loss hits the trigger point.

* LIMITS: $2 million to $100 million.

* TYPICAL RETENTION: $100,000.

Source: John B. Collins Associates Inc.

Why Buy an Industry Loss Warranty?

* Contracts are easy to understand.

* Retention is fairly small.

* Buyers don't have to provide any underwriting information.

* Pricing can be more competitive.

* Reinsurers may not give the buyer credit for changes made to its portfolio.

* The contracts can Provide broad coverage, Fill a shortfall in traditional programs, and Be purchased quickly.

Why Sell an Industry Loss Warranty?

* Easy to price, underwrite and administer.

* Does not require a huge staff.

* Easy way to get into the insurance market.

* Eliminates surprise from small losses, small events.

* Eliminates the risk of poor underwriting information.

* Can tailor the coverage based on the seller's portfolio.

* Pricing can be profitable.

Source: John B. Collins Associates Inc.

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Swiss Re Group

A.M. Best Company # 85010

Distribution: Reinsurance brokers

Quanta Insurance Group

A.M. Best Company # 89073

Distribution: Brokers and direct

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