Speed and simplicity

Another period of intense catastrophe activity in the first six months of 2011 has proved disastrous for many. But as rates in the traditional reinsurance industry respond, this is also true in the Industry Loss Warranty market, which is also seeing rate increases.

A recent JLT Re report noted that although “the vast majority of reinsurers” have already blown their 2011 catastrophe budgets, Industry Loss Warranty prices have seen “increases across the board” from moderate to significant depending on the covered territories/perils, driven by “large-scale losses coupled with the recent model release of RMS 11.0 for US Hurricane”, along with “deteriorating combined ratios, uncertainty around pricing of risk and resulting impact on cost of capital”.

However, there are also more seasonal drivers to consider, argues Paul Schultz, president of Aon Benfield Securities. “Clearly, as we get closer to the start of the US hurricane season, rates tend to harden in general, so this is a typical reaction in any underwriting area,” he says.

“We are seeing ILW rates, especially for US hurricane exposed capacity and in particular Florida, probably up in the range of 20 to 25 percent. This hardening of pricing is due to capacity issues and an increase in ‘back-up purchases’ in retro and other types of back-up lines, which were required following the recent international losses.”

Current market conditions aside, ILWs have a number of characteristics that have allowed them to grow in popularity as an alternative method of risk transfer, the foremost being their simplicity.

“From the buyer’s perspective, ILWs are an easy transaction to execute,” says Stephen Velotti, chief underwriting officer at Juniperus Capital Limited. “Because they are an easy transaction, they require less infrastructure and staff to operate—for example, a bank could set up an entity to sell industry loss warranties within days of purchasing the industry loss data.”

In comparison with other insurance linked securities, due to their lower administration costs, ILWs tend to be considerably cheaper to buy than cat bonds and can be executed at a much greater speed.

“ILWs are what we would call a spot market purchase, where you can make a decision to buy some cover and that can be transacted very quickly,” says Schultz. “The documentation involved is also pretty simple, so the ease of execution and ability which ILWs provide to trade in and out on an on-the-spot basis make this attractive cover.”

Current market conditions have also provided the potential for ILWs to grow in the retrocessional market, according to Greg Habay, senior vice president at JLT Re. “In late Q2 2011, there was a little bit of a dislocation and shortage on the UNL retro side, with some capacity waiting on the sidelines which could come in and provide some relief during the second half of the year,” he says.

“Using syndicates as an example, their international portfolios have been hit pretty hard on the catastrophe side. They are either through the first layer or even all layers of their programmes; hence, they are either in their reinstated limit if available or are bare and have no cover.

This means that for them to go out into the market in late Q2 2011 and buy retro UNL cover is going to be quite expensive, because they are essentially at the mercy of the sellers. Understandably, that is not a very comfortable position to be in, but their PML management can be addressed to a great extent via ILW protections.

“In order to obtain UNL cat retro cover, the buyer would have to provide a fair amount of granular information on their book, such as giving latest estimates of losses and forward-looking plans on exposure/ premium—so it’s pretty involved. It also takes time and the pricing may be very hefty. So it’s pretty logical to think that instead of going out into the market with a UNL retro programme, why don’t I look to buy industry loss warranties?”

Because of their flexibility and competitive pricing, some believe that ILWs, along with other alternative forms of risk transfer such as catastrophe bonds and sidecars, could even begin to pose a threat to traditional catastrophe reinsurance.

A recent report by FBR Capital Markets noted concern over what it perceived to be “longer-term” competition posed to the reinsurance industry by “alternative sources of reinsurance capacity”, which “allow investors to participate in market hardening on a short-term basis, without the trouble of long-term commitments”.

However, others believe that there will always be a place for traditional reinsurance.

“There are various ways for companies to transfer risk and I think that UNL is a great product, as it is 100 percent correlated with a buyer’s results and there is no basis risk, so it tracks very well with the underlying portfolio,” says Habay.

Others have pointed out that ILWs cannot always provide the same kind of protection for insurers that traditional reinsurance does.

“If there is a sales man in a town who sells lots of policies and then the town is taken out by a tornado, that won’t be an industry loss under an ILW, but could be catastrophic to you and so you need some protection against that focused loss that can hit your company and not others,” says Clive O’Connell, who is partner and head of the commercial risk and reinsurance team at Barlow Lyde and Gilbert.

“Some of the trigger points in ILWs which one sees represent very large losses indeed, with some being in terms of Hurricane Andrew or Katrina before they even kick off. Generally speaking, people need protection from much lower points than those, especially where they have focused and concentrated exposure themselves.”

Rather than posing a direct threat to traditional reinsurance, most see ILWs as complementing reinsurers’ traditional offering.

“I don’t think that the major reinsurers have ever seen the capital markets as a serious threat to their business model,” says Luca Albertini, chief executive officer of Leadenhall Capital. “To the contrary, historically they have used the capital markets to make their own balance sheet more efficient.”

If anything, ILWs can help reinsurers to grow their business relationships, argues Albertini.

“When I used to originate new business in capital market form, I always tried to present the capital markets and traditional reinsurance as two products which complement each other. For example, if you are already supply ‘x’ billion dollars’ worth of traditional reinsurance to a company, then to grow that relationship beyond that point might be uncomfortable for both parties. So what else can we do to go above and beyond that? This is where capital markets instruments can come into play.”

So what is the future for ILWs?

“We view alternative markets in general, including both ILWs and cat bonds, as a complementary source of capital,” says Schultz. “Most buyers are going to want to purchase cover which they can claim when they have actual losses, because that is the perfect hedge for the buyer. There are some motivating factors which cause interest in indexed or non-U&L covers, but the primary source of capital will continue to be bought on an actual loss recovered basis.”

Habay agrees, seeing a further chance for ILWs to improve and global trading volume to increase.

“Do I think that ILWs are growing? Yes I do, both in the traditional sense of being based on an industry loss index and a parametric trigger or ones that are more customised,” he says. “ILWs are becoming more sophisticated in terms of tailoring deals to buyers’ exposures and views of risk.”

Others believe these developments can also be driven by external factors.

“What I think will be interesting is as modelling steadily improves, you will find that the basis risk declines and the attraction toward commoditised contracts will increase,” says Robert CB Miller, a consultant of Environova Consulting.

So rather than completely taking over the market, it would appear that ILWs, along with other alternative methods of risk transfer, will continue to develop and improve, providing more options to those seeking protection, rather than simply replacing traditional reinsurance in its current form.

A history of industry loss warranties

Although ILWs have only really begun to be used over the last 20 years in their current form, they are very similar in many ways to an older instrument called a tonner.

“Tonners were policies which were sold in the market where there was no insurable interest and no interest in the underlying loss, but one could buy a cover against the tonnage of shipping that sank,” says O’Connell.

“In 1909, marine tonners were made illegal and criminal, on the basis that they encouraged people to gamble on the sinking of ships and therefore gave them an interest in ships sinking.”

As a consequence, marine tonners disappeared, but non-marine tonners persisted right through to the late 70s and early 80s.

“There was a big cause célèbre in the early 80s, where Lloyd’s brought disciplinary proceedings against someone who was perceived to be placing too many pessimistic tonners, with the consequence being that the individual was expelled from Lloyd’s and then Lloyd’s disallowed the practice through by-law.”

While tonners could no longer be used, similar financial instruments, namely derivatives, were developed following a crisis in capacity after Hurricane Andrew.

“If you actually scratch the surface of a derivative, it is conceptually not that different from a tonner, with the only differentiation being that a derivative is offered by a bank,” says O’Connell.

“However, insurers can’t handle derivatives, as they could only be handled by banks, so the concept of industry loss warranties was developed, and apart from one very important issue, they are, essentially, what a tonner or a derivative is, because it is a gamble on an industry loss of a certain level.

“The difference is that in addition to the industry loss, you also have to an insurant loss—i.e. you actually have to have an insured interest in a level of loss as well, which means that it is no longer a wagering agreement and that it is an insured agreement.

“However, industry loss warranties are modelled on the likelihood of an industry loss of that scale, so the actual insured loss is not so relevant to the rating, but absolutely essential to the enforceability and the regulatory approval of the instrument.”