Industry Loss Warranty

Industry Loss Warranties, often referred to as ILWs, are a type of reinsurance or derivative contract through which one party will purchase protection based on the total loss arising from an event to the entire insurance industry rather than their own losses. For example, the buyer of a "$100mm limit US Wind ILW attaching at $20bn" will pay a premium to a protection writer (generally a reinsurer but sometimes a hedge fund) and in return will receive $100mm if total losses to the insurance industry from a single US hurricane exceed $20bn. The industry loss ($20bn in this case) is often referred to as the "trigger." The amount of protection offered by the contract ($100mm in this case) is referred to as the "limit." ILWs could also be constructed based on an index not linked to insurance industry losses. For example, Professor Lawrence A. Cunningham of George Washington University suggests adapting similar mechanisms to the risks that large auditing firms face in cases asserting massive securities law damages.

These agreements are usually documented as reinsurance contracts between the parties. If so, in addition to the industry loss trigger the contract will include an "ultimate net loss clause" which specifies that the protection buyer must demonstrate that they have lost a specified amount as well.

ILWs are sometimes referred to as Original Loss Warranties (OLWs) or Original Market Loss Warranties, but this usage is becoming increasingly rare.

The first contracts of this type were traded in the 1980s. This market remained fairly small (though influential in price setting for reinsurance as these contracts are more consistent than most reinsurance treaties) through Hurricane Katrina. The entry of many hedge funds into 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 $2bn to $10bn outstanding (Aon plc, Nephila). 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.

Property Claims Services, a division of the Insurance Services Office (ISO), is generally the source for industry loss estimates for US perils. SIGMA, a division of Swiss Re, is often the source for such losses outside the US, with Munich Re's NatCAT Service appearing more and more often on ex-US business.

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