It's the quiet ones you've got to watch out for, discovers Helen Yates. Industry loss warranties may not have received as much press attention as other alternative products, but they're attracting massive investor interest.

With all the fuss about sidecars and cat bonds, one of the industry's original techniques for transferring risk to the capital markets has largely been ignored. Carvill president Steve Breen's judgement on industry loss warranties (ILWs), where demand has shot up by 35% since Hurricane Katrina devastated New Orleans over a year ago, is that "they haven't had as much publicity as sidecars and cat bonds because they've been around for so long. But they now represent a new opportunity just when the market is in need of one."

It is difficult to measure the exact size of the ILW market as these collateral-backed transactions are largely done privately. But the volume of capital entering this sector has leapt dramatically in the year since Katrina kick-started a process that would see a huge capacity squeeze for US catastrophe reinsurance and retrocession. Breen believes over $4bn of limit was placed in 2006, an amount he wouldn't be surprised to see double or even quadruple in the next two years. "Compared to cat bonds and sidecar deals, ILWs are very much under the radar screen," he explains. One market in which ILW contracts have become invaluable is retrocession. They are currently believed to account for as much as 20% of this sector, which has all but disappeared since last year's dramatic storm season.

Global warning

Hurricane Katrina was a warning that the industry had been underestimating the true nature of hurricane risk. "Katrina was a big wake-up call for the industry," says Carvill chief executive John Cavanagh. "People have become a lot more conservative." There is now a general agreement among the catastrophe modelling community that we are in a period of heightened hurricane activity, reflected in a series of new short-term models. Whether this heightened activity is due to global warming or the Atlantic Multi-Decadal Oscillation (a natural climatic cycle), or a combination of the two, continues to be hotly debated. What it means for reinsurers is greater natural catastrophe exposure for the same amount of business as just a year ago.

But it isn't just storm activity that has increased, insured values along the catastrophe-exposed US coastline have also soared and will only increase further as population density grows and property development continues unabated. Additionally, as 9/11 demonstrated only too well, a large loss like Katrina confirmed some surprising correlations of risk.

Rating agencies reacted to Katrina with a new set of capital requirements, pushing many reinsurers to reduce their exposure to US windstorm and increase their diversification. The knock-on effect was reduced capacity in this area and, on some lines, 100% premium rate increases. And Breen believes this is unlikely to change any time soon. "The rating agencies and the modelling agencies are currently pursuing a different path."

In this scenario, it is clear that any new capacity from alternative risk transfer solutions is invaluable, which is reflected in the dramatic growth of catastrophe bonds and sidecars. According to Benfield's estimations these are jointly expected to attract over $8bn in 2006. Capital is literally flowing into this area, increasingly from hedge funds and private equity investors. This is a direct result of the opportunities available, believes Fitch senior director Mark Rouck. "The water seeks its own level," he explains. "If the opportunities were overstated you'd see capital start to seep out of this sector."

What are ILWs?

Like a traditional catastrophe excess-of-loss reinsurance contract, ILWs specify territories, attachment points, perils and time periods. The main difference is that payment under ILW contracts is based on two triggers: the insured loss of the buyer (the indemnity) and an assessment of the total insurance loss arising from an event as judged by as independent third party authority, such as ISO's Property Claim Services (PCS). And therein lies the advantage. By being index-based there is an obvious method of measurability. "Everyone can understand the PCS index," insists Cavanagh.

Where ILWs were once considered reinsurance of last resort - something that might be purchased after all other forms of traditional and non-traditional reinsurance had been exhausted - they are becoming an important part of overall reinsurance buying strategies. Breen believes they are one of a growing number of "tools in the box for everyone to use" and, if used correctly, should be an offensive and not a defensive mechanism. "ILWs have to be a strategic part of your reinsurance purchasing instead of being a gap fill. They have to sit alongside your UNL (ultimate net loss) protections, your cat bonds and your sidecars."

ILWs began life in the 1980s as an alternative source of capacity in the specialty markets, particularly in retrocession and aviation, where recovery was triggered when the size of the loss reached an agreed level by using the hull and liability valuation. As long as the loss trigger is index-based it fits with ILW criteria. "PCS has to report a loss, Sigma has to report a loss - which they do - and you either pay or you don't. It's no cry cover," says Breen.

ILWs are attracting massive interest from hedge funds. "Hedge funds thrive on market opportunity and we're in a very volatile period," explains Cavanagh. But there are other attractions. Hedge funds typically enjoy a clean exit strategy and ILWs generally have a very straightforward 12-month lifespan. In addition, the returns for taking on peak risk can be very high - and hedge funds are already expecting to make a windfall from betting on hurricanes in 2006. "If there is a $20bn windstorm - Florida only - they can then relate that back to a return period, ie the probability of loss through RMS or EQE, whichever model they want to use," explains Breen. "That gives them a probability and they get multiples of that probability for taking the risk."

There is very little cost attached to putting an ILW contract together, hence the overheads are much lower than they are for cat bonds and sidecars. Essentially all the client pays is the premium. "They're very fluid and very flexible. Provisional cost is basically zero and there's no lawyers fee, modelling agency fee or structuring fees - you simply pay your premium and all costs are deducted from that, no hidden costs for the buyer," says Breen. Additionally, investors are not reliant on the buyer for their risk selection skills and the loss modelling used is transparent. And because they are fully collateralised ILW transactions are looked upon favourably by the rating agencies.

There only appears to be one potential downside with ILWs - basis risk - which is the risk that the buyer incurs losses but the industry's losses (as advised by PCS) fall short of the trigger used in the contract. Another concern is the longevity of investor interest. All forms of alternative risk transfer - securitisation, cat bonds, sidecars and ILWs - rely on continuing interest from capital market investors. The industry may currently be enjoying a steady supply of capital from institutional investors, hedge funds and private equity firms, but it doesn't follow that this will always be the case. But Breen is confident these investors are here to stay and that going forward the industry must work with them. "I really believe they can contribute to taking us as an industry to the next level and we have to embrace them," he advises.


- 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 programmes and be purchased quickly.

- 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.