ILWs have gained in popularity in recent years, particularly in the Bermuda reinsurance market.


Industry Loss Warranties (ILWs) are contracts that provide coverage or financial protection to individual reinsureds by reference to an industry’s total insured losses, as reported by an index service provider, rather than the reinsured’s own actual losses.

Developed in the 1980s, ILWs have become attractive in recent years, particularly in the Bermuda reinsurance market (which has seen 34 new (re)insurers registered in the first six months of 2013, including 12 special purpose insurers (SPIs)), because they:

  • provide additional capacity;
  • are easy to buy (needing less placement information than traditional indemnity-based reinsurance);
  • have fairly low transaction costs;
  • have relatively low pricing risk;
  • provide a useful way to hedge against other risks in a portfolio;
  • can be structured as reinsurance or derivate contracts; and
  • are perceived to be less susceptible to disputes over cover than traditional reinsurance.

As an alternative reinsurance product, ILWs form just one part of the broader convergence of reinsurance and capital markets in Bermuda, including as insurance-linked securities funds, catastrophe bonds, collateralised reinsurance, and hedge fund-backed reinsurance providers.

Although ILWs suffer from some degree of basis risk (arising from the difference between the reinsured’s actual loss and the chosen index’s estimate of industry losses), the Bermuda reinsurance market’s ability to manage basis risk has evolved over time, particularly now that the index service providers offer more granular and narrowly focused indices.

There are a variety of forms of ILW available, including live cats (where an event is imminent), dead cats (where an event has occurred but losses have not yet been estimated), and back-up covers (which provide protection for certain events following a catastrophe, such as fire or floods).

Dual triggers (which include an ‘indemnity’ trigger that requires the reinsured’s proof of actual loss as well as the industry loss trigger) are sometimes used to satisfy the English law requirements of an insurable interest and qualify as reinsurance for regulatory purposes, but this is a less pressing issue under Bermuda law, given the “designated investment contract” provisions of s57A of Bermuda’s Insurance Act 1978.

The ‘selling points’ of ILWs are their certainty and transparency, the limited scope for coverage disputes given the reliance on an index published by independent third parties (including PCS, Sigma, PERILS, and NatCatSERVICE), and the prospects of a prompt settlement payment once triggers have been satisfied and the industry loss estimates published (as opposed to traditional reinsurance contracts, where the presentation of claims and settlement payments can be delayed for a variety of reasons).

Fertile area for disputes

But it would be wrong to assume that there is no scope for dispute. Indeed, given the number of recent catastrophes (and the financial pressures caused by the deterioration of the global economy generally), it is not surprising that the volume of ILW disputes has been increasing (although no disputes have yet resulted in a significant reported court decision). Superstorm Sandy has not contributed substantially to the trend because estimated insured losses have not reached US$20bn, the key trigger for a number of ILWs.

A fertile area for emerging disputes is in the interpretation and application of the trigger wording, and its relationship with the chosen index or indices. There have been several cases in which the trigger and the chosen index do not properly align, including, for example, situations where:

  • The chosen index does not estimate self-insured losses, but the trigger (at least arguably) includes losses sustained by wholly owned captive insurance companies.
  • The chosen index does not estimate losses arising from the particular type of loss specified in the trigger (for example, the trigger includes all insured losses, defence costs, and loss adjustment expenses but the chosen index, such as PCS, does not include ocean marine or offshore energy losses, defence costs or loss adjustment expenses).
  • The chosen index does not estimate losses arising from the geographical area specified in the trigger (eg, the trigger includes Caribbean losses but the chosen index, such as PCS, only covers North America);
  • The chosen index estimates losses arising from a particular type of peril that is excluded by the trigger (resulting in difficult questions of allocation and aggregation, particularly where some index service providers provide limited information regarding their methodologies and loss estimate calculations).
  • There are two or more indices chosen, which provide different loss estimates that are difficult or impossible to reconcile.
  • A chosen index combines two related events, but the trigger treats them as separate (for example, the World Trade Centre attacks).
  • Furthermore, just as claims have been made in the context of other financial products against independent ratings agencies, independent fund administrators and net asset value calculation agents, there is also scope for claims to be made in the ILW context against independent index service providers, and coverage disputes relating to triggers calculated by reference to third-party indices, whose estimates might be the subject of challenge.

Lacking transparency

It has been suggested, for example, that some index service providers’ loss estimates lack transparency in their methodologies, data sources and calculations; such criticisms may invite further scrutiny and complaints.

The Mariah Re litigation in the US District Court, Southern District of New York, provides an interesting example of allegations being made in this context. Although the litigation relates to a catastrophe bond issued by a Cayman Islands special purpose vehicle rather than an ILW issued by a Bermuda SPI, allegations have been made by the Cayman SPV’s liquidators that the reporting and calculation agents, PCS and AIR, wrongly re-issued a catastrophe bulletin to the benefit of the cedant and to the disadvantage of the bond issuer and its investors.

It remains to be seen whether any of these allegations are proved, but the case serves as a reminder to the Bermuda market that ILWs, and other alternatives to traditional reinsurance in the brave new world of convergence, cannot eliminate the risk of disputes.

Alex Potts is special counsel and Mark Chudleigh is a partner at Sedgwick Chudleigh Bermuda

We say

  • The (re)insurance industry has suffered from a series of catastrophic events over the past few years. So it is no surprise that the industry is turning to ILWs. However, those looking to ILWs as a solution need to be careful with definitions and the wordings that define the thresholds.
  • Disputes are likely if indices and thresholds do not match. This is likely to happen when an index does not estimate losses arising from a geographical region named under the threshold or an index is nominated which does not estimate losses arising from a particular type of loss named under the threshold.