ILS Intelligence
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,
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.”
52 | INTELLIGENT INSURER | September 2011
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