What is an Industry Loss Warranty (ILW)?
An Industrial Loss Warranty (ILW) is a reinsurance Where derivative contract that pays when the financial losses suffered by an industry exceed a specified threshold. Also known as first loss guarantees, the contracts are often underwritten by hedge funds or reinsurance companies, which are better able to absorb large losses than smaller insurers.
Key points to remember
- An Industry Loss Guarantee (ILW) is a reinsurance or derivative contract that comes into effect when losses incurred by an industry exceed a specified threshold.
- Hedging is usually triggered when an index provider declares that the relevant threshold has been reached.
- Usually, an insured’s own losses do not affect whether or not they receive a payout, although there are exceptions.
- Industry loss guarantee contracts are often annual and can even be purchased during and after a catastrophic event.
- They are usually underwritten by reinsurance companies or hedge funds.
How an Industry Loss Guarantee (ILW) Works
Industry loss guarantees compensate companies – usually insurers – when a catastrophic event severely and widely affects their industry. In exchange for payment of a primethe insured will receive compensation if the industry-wide damage exceeds a predetermined threshold.
Insurers may specialize in a particular range of cover and underwrite policies in a limited geographical area. A company can write Home Insurance policies in Florida, for example. In most cases, the frequency and severity of claims are limited to a small area, such as when a lake floods and damages a few homes.
However, during disasters, the number of damaged properties and the extent of the damage can increase rapidly, potentially pushing the insurer to insolvency. To protect against catastrophes, insurers can purchase industry loss coverage.
Coverage in the event of an industrial disaster guarantee is usually triggered by a third party reporting that an event has occurred, rather than the insured reporting that they have suffered a loss. This third party can be a index responsible for measuring the loss of the industry. 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 incurring a specified amount of loss.
Example of Industrial Loss Warranty (ILW)
Consider an insurer who underwrites property insurance policies in a state that is occasionally hit by hurricanes. Because hurricanes can damage large swaths of a geographic area and simultaneously impact large numbers of policyholders, the insurer purchases industry loss coverage with a coverage limit of $125 million. dollars. which triggers when more than $10 billion in losses are reported. This means that if more than $10 billion in losses are reported as a result of a hurricane, the insurer will receive $125 million.
Types of Industry Loss Guarantees (ILW)
Industry loss guarantee contracts are typically annual and can even be purchased during and after a catastrophic event unfolds.
For example, there are live chat contracts, which are negotiable while an event is happening; dead cat contracts, which can be purchased after the event has occurred provided the total industry loss amount is not yet known; and emergency covers, which provide protection against follow-up events resulting from disasters, such as fires or floods.
Critique of Industry Loss Guarantees (ILW)
Like most forms of Insurance, industry loss guarantees are not free from controversy. A particular area of scrutiny is the trigger specified in the contract and its relationship to the named indices responsible for indicating whether it has been reached.
In the past, there have been instances where the agreed trigger and the index chosen to represent it were not properly aligned. This could be due to something as simple as the index monitoring a different region of the world, not tracking certain events covered by the contract, or two indices being used that produce very different and conflicting loss estimates.
The decade the industry’s first Loss Guarantee (ILW) contracts were traded.
Industry Loss Warranty (ILW) History
The industry’s first loss-guarantee contracts were negotiated in the 1980s and were fairly low-key. The market remained small until a rush hedge funds entered the fray and the market for retrocessional reinsurance (reinsurance of reinsurers) collapsed.
Although the industry loss guarantee market has no swap or source of compensation to track volumes, its value was estimated at between $5.5 billion and $6 billion in January 2019.