ILW contracts are just one of the products that are changing the way the reinsurance market does business. The advent of new sources of capital into the reinsurance market has led to the growth in alternative reinsurance protections. But can these allegedly simpler, cheaper products really offer a true alternative to traditional reinsurance protection? A number of recent catastrophes, both man-made and natural, have called into question the efficacy of ILWs and, in particular, the parties’ respective expectations in the event of a major loss event.
The problems and pitfalls of ILWs
The trigger is the cornerstone of any ILW contract. It must be carefully selected for the risk in question to ensure that the ILW contract responds in accordance with the reasonable expectations of both parties.
The concept of an ILW is relatively simple. A recovery under an ILW policy is contingent upon a certain event (usually a natural catastrophe but not always) which causes losses to the entire insurance industry equal to or in excess of a predetermined amount. This industry loss is referred to as the “trigger”. To try to avoid issues as to whether the industry loss reaches the predetermined level, the parties often agree to use an external “index” prepared by an independent third party as their reference source.
In the circumstances, not knowing the ins and outs of the specific industry loss index used in an ILW policy can materially affect whether or not the policy responds to a given loss situation as anticipated. Many of the disputes which have arisen in relation to ILWs have focused upon the trigger mechanism used. In particular, disputes have arisen because independent trigger indices which are unsuitable for the loss in question have been selected or because one or both parties wishes to challenge the operation of the chosen index.
There are a number of established indices which report industry loss estimates. Each index is different and it is thus essential that all parties are familiar with the index, the methodology used to calculate the estimate and what is covered/excluded from such estimates. The main four indices are:
- PCS: reports insured property losses resulting from catastrophes in the US, Puerto Rico, the US Virgin Islands, and Canada.
- Sigma: reports insured property and business interruption losses (but excludes liability and life insurance losses) on a worldwide basis resulting from natural catastrophes and man-made disasters.
- PERILS: reports property losses resulting from European Windstorm, UK Flood and Italy Earthquake and Flood.
- NatCatSERVICE: reports loss events due to natural hazards resulting in property damage or bodily injury.
The indices generally exclude liability losses from their published estimates because property losses tend to be ascertained quite quickly, allowing the index to publish its estimate sooner (which should translate into a swift settlement of any claim under an ILW policy). By contrast, it can often take many years for the true extent of liability losses to be quantified. Further, for natural catastrophes, the likelihood of liability claims and losses is limited, again emphasising the focus of all indices on first party loss statistics. However, in the case of man-made disasters, where there are likely to be significant liability losses, relying on an index which excludes liabilities can cause issues.
Many ILW contracts retain a degree of flexibility, allowing a purchaser to challenge the figures produced by the referenced index. This has given rise to a number of arbitrations over the suitability and accuracy of certain indices, and the thorny question of whether liability losses should be included or excluded.
Problems can also arise with regard to captives. Are losses protected by a company’s captive included as part of the insured market loss? Given that the risk was not placed in the commercial arena, it is arguable that the losses of a captive should be excluded from the calculation. At the same time, some captives insure significant sums and whether their losses are included or excluded could be critical in calculating the size of a loss to trigger payment under an ILW policy.
These are just a few of the issues which can and do arise from a poorly drafted ILW policy; it is worth being mindful of these potential pitfalls in order to minimise the chances of a dispute arising. For a more in-depth review of ILWs, please click here.