indemnification of the insured or reinsured for the losses suffered. Another
way to transfer insurance risk, which is particularly important in its transfer
to the capital markets, is to link the payments to a certain value of an index
as opposed to basing it only on the reimbursement of the actual losses
suffered by a specific entity.
An example of such an index would be that of
the level of losses suffered from a hurricane in a particular region by the
whole insurance industry. Another example would be a purely parametric
one based on the intensity of a specified catastrophic event without referencing
actual insured losses.
The two main types of insurance-linked securities whose payout depends
on an index value are insurance derivatives and industry loss warranties.
Industry loss warranties (ILWs) and catastrophe derivatives (a subset of
insurance derivatives) were the first insurance-linked securities to appear.
ILWs were first introduced in the 1980s and at the time they were often
referred to as original loss warranties (OLWs) or original market loss
The first catastrophe derivative contracts were developed in
1992 by the Chicago Board of Trade (CBOT). Both types of contract have
since evolved; their markets have evolved as well. ILWs in particular are
now playing an important role in the transfer of catastrophe risk from insurance
to capital markets.
The use of an index as a reference offers the transparency and lack of
moral hazard that are so important to investors. The ease of standardisation
is also important. One of the key advantages, not yet fully realised, is the
liquidity and price discovery that come with exchange-traded products such
as catastrophe derivatives.
This article provides an overview of ILWs and catastrophe derivatives
and explains the considerations used in their analysis by investors and
insurers. It then describes the standard indexes used in structuring these
securities and gives some specific examples.
The focus is on property insurance
risk transfer; insurance derivatives linked to mortality and longevity
are explained in the chapters dealing with mortality and longevity risk
trading, while weather derivatives are discussed in Chapter 8. Finally, the
present chapter examines the trends in the market for ILWs and catastrophe
derivatives and the expectations for its growth and evolution.
ROLE OF AN INDEXIndex-linked investments are common in the world of capital markets. The
indexes used in insurance and reinsurance risk analysis are typically related
to the level of insurance losses; these are not investable indexes and neither
are their components. A derivative contract can still be structured based on
such an index, but the underlying of the derivative contract is not a tradable
In the transfer of insurance risk, an index is chosen in such a way that
there is a direct relationship between the value of the index and the insurance
losses suffered. There is, however, a difference between the two: the
basis risk. This risk is not present when a standard reinsurance mechanism
While index-linked products are used primarily for the transfer of true
catastrophe risk, there is a growing trend of transferring higher-frequency
(and lower-severity) risk to the capital markets. The indexes used do not
necessarily have to track only catastrophic events.
CATASTROPHE DERIVATIVES DEFINEDIn financial markets, a derivative is a contract between two parties the value
of which is dependent on the value of another financial instrument known
as an underlying asset (usually referred to simply as an underlying). A
derivative may have more than one underlying. In the broader sense, the
underlying does not have to be an asset or a function of an asset.
Catastrophe derivatives are such contracts, with an underlying being an
index reflecting the severity of catastrophic events or their impact on insurance
Futures are an example of derivative instruments. Catastrophe futures are
standardised exchange-traded contracts to pay or receive payments at a
specified time, with the value of the payment being a function of the value of an index. Unlike the case of traditional financial futures, physical delivery
of a commodity or other asset never takes place.
Options are another example of financial derivatives; they involve the right to buy (call option)
or sell (put option) an underlying asset at a predetermined price (strike). In
the context of catastrophe derivatives, of particular importance are call
spreads, which are the combination of buying a call at a certain strike price
and selling a call on the same underlying at a higher strike, with the same
The calls can be on catastrophe futures. Using a call spread
limits the amount of potential payout, making the contract somewhat
similar to reinsurance, where each protection layer has its own coverage
Binary options provide for either a fixed payment at expiration or,
depending on the value of the underlying, no payment at all. In other words,
there are only two possible outcomes. They are also referred to as digital
There are numerous ways that catastrophe derivatives can be structured.
The payout may depend on a hurricane of specific magnitude making a
landfall in a certain area; on the value of total cumulative losses from hurricanes
to the insurance industry over a certain period of time for a specified
geographical region; or on the value of an index tracking the severity of an
earthquake at several locations.
The flexibility in structuring an over-thecounter
(OTC) derivative allows hedgers to minimise their basis risk. At the
same time, there are significant advantages to using standard instruments
that can be traded on an exchange.
Exchange-traded derivatives are more
liquid, allow for quicker and cheaper execution, provide an effective mechanism
for managing credit risk and bring price transparency to the market,
all of which are essential for market growth.
Derivatives versus reinsuranceAll insurance and reinsurance contracts may be seen as derivatives, albeit
not recognised as such by accounting rules. Technically, they would be call
spreads, which corresponds to policy limits in insurance. From the point of
view of the party being paid for assuming the risk, an excess-of-loss reinsurance
contract can be seen as being equivalent to selling a call with the
strike at the attachment point and buying a call with the strike equal to the
sum of the attachment point and the policy limit. The “underlying” in this
case is the level of insurance losses.
The true derivatives such as insurance catastrophe derivatives have a
better defined and stable underlying and are accounted for as financial derivative products. Insurance accounting is not allowed for these products.
This topic will be revisited later in the article.
INDUSTRY LOSS WARRANTIES DEFINEDThe term “industry loss warranty” (ILW) has been used to describe two
types of contract, one of them a derivative and the other a reinsurance
contract. In its most common form, an ILW is a double-trigger reinsurance
contract. Both trigger levels have to be exceeded for the contract to pay. The
first is the standard indemnity trigger of the reinsured suffering an insured
loss at a certain level, that is, the ultimate net loss (UNL) trigger.
The second is that of industry losses or some other index level being exceeded. The
index of industry losses can be, for example, the one determined by the
Property Claim Services (PCS) unit of Insurance Services Office, Inc. (ISO).
An ILW in a pure derivative form is a derivative contract with the payout
dependent only on the industry-based or some other trigger as opposed to
the actual insurance losses of the hedger purchasing the protection. Even
though labelled an ILW, it is really an OTC derivative such as the products
The choice between the ILW reinsurance and derivative forms of protection
has significant accounting implications for the hedger. It is typically
beneficial for the hedger to choose a contract that can be accounted for as
reinsurance, with all the associated advantages. This is why the vast
majority of ILW transactions are done in the form of reinsurance.
The majority of ILWs have a binary payout, and the full amount is paid
once the index-based trigger has been activated. (We assume that the UNL
trigger condition, if present, has been met.) However, some ILW contracts
have non-binary, linear payouts that depend on the level of the index above
the triggering level. There seems to be general market growth in all of these
MARKET SIZEWhile the size of the catastrophe bond market is known, it is difficult to estimate
the volume of the industry loss warranty and catastrophe derivative
market. The OTC transactions are rarely disclosed, leading to a wide range
of estimates of market size. The only part of the market with readily available
data is that of exchange-traded catastrophe derivatives. The exchanges
report the open interest on each of their products.
While its size is not very big (with no estimates exceeding US$10 billion
in limits), this market is important as a barometer of reinsurance rates and their movements. Exchange-traded products bring price transparency to the
traditionally secretive reinsurance market. The growing activity of ILW
brokers is leading to increased transparency in the OTC markets as well.
While not directly comparable to traditional reinsurance contracts, catastrophe
derivatives and ILWs provide an important reference point in
pricing reinsurance protection.
It is likely that in terms of total limits, the ILW and catastrophe derivative
market is between US$5 and US$10 billion. This number does not include
catastrophe and other insurance derivatives linked to mortality and
longevity; only property and casualty insurance risks are included.
The market has been growing, but the growth has not been steady. Similar to the
retro market (of which some consider this market a part), its size is particularly
prone to fluctuations based on the rate levels in the traditional
reinsurance market. The one part of the market that we can see growing is
that of exchange-traded insurance derivatives. However, exchange-traded
products are currently a relatively small part of the overall marketplace.
KEY INDEXESA number of indexes have been used in structuring insurance derivatives
and ILW transactions. They include indexes tied directly to insurance losses
and those tied to physical parameters of events that affect insurance losses.
The overview below focuses on the indexes providing the most credible
information on the level of insured industry-level property losses due to
Property Claim ServicesPCS, a unit of ISO, collects, estimates and reports data on insured losses
from catastrophic events in the US, Puerto Rico and the US Virgin Islands.
While every single provider of catastrophe-insured loss data in the world
has at times been criticised for supposed inaccuracies or delays in reporting,
PCS is generally believed to be the most reliable and accurate.
In the half a century since it was established, the organisation has developed sound
procedures for data collection and loss estimation. It has the ability to collect,
on a confidential basis, data from a very large number of insurance carriers
as well as from residual market vehicles such as joint underwriting associations.
Other data sources are used as well. Insurance coverage limits, coinsurance, deductible amounts and other factors are taken into account by PCS in estimating insured losses. Estimates are provided for every catastrophe which is defined by PCS as an event that causes US$25 million or more in direct insured property losses and affects a significant number of
policyholders and insurers. Data for both personal and commercial lines of
business is included.
Loss estimates are usually reported within two weeks of the occurrence of
a PCS-designated catastrophe (and PCS provides the event with a serial
number). For events with likely total insured property loss in excess of
US$250 million, PCS conducts re-surveys and reports their results approximately
every 60 days until it believes that the estimate reasonably reflects
insured industry loss.
These larger events are the ones of interest for catastrophe
derivatives and ILWs. Figure 5.3 shows an example of PCS loss
estimates for Hurricane Ike at various time points, in reference to the settlement
prices for two of the exchange-traded catastrophe derivatives that use
While general catastrophe loss data is available dating back to the establishment
of PCS in 1949, the more detailed data by geographic territory and
insurance business line is available for only the more recent years.
In Table 5.1, opposite, we can see the development of industry-insured
loss estimates for the largest catastrophic events since 2001.
The time between the occurrence of a catastrophic event and reporting of the final
estimate could vary significantly depending on the event and complexity of
the data collection and extrapolation. Of the events shown in Table 5.1,
Hurricane Katrina had 10 re-survey estimates issued, with the last one
almost two years after the event occurrence.
However, the changes over the year preceding the reporting of the final estimate were minuscule. The 2008 Hurricane Gustav had the final estimate issued in less than five months,
with that final number not changing from the first re-survey estimate.
Insured loss estimates for catastrophes that happened before those shown
in Table 5.1 often lacked precision, even though they did not take longer to
obtain. For the 1994 Northridge earthquake in California, the preliminary
estimate increased 80% in two months, and the final estimate was five times greater than the original number.
However, we have to recognise the fact
that the methodologies employed by PCS have been changing; current estimation
techniques are more reliable given the possibly disproportionate
focus on the actual reported numbers years ago.
Catastrophe loss indexes based on PCS data are the basis for many ILW
and catastrophe derivative transactions, as well as for catastrophe bonds
and other insurance-linked securities. Both single-event and cumulative
catastrophe loss triggers can be based on PCS indexes.
PerilsIncorporated in 2009, PERILS AG was created to provide information on
industry-insured losses for catastrophic events in Europe, similar to the way
PCS provides information in the US. The plans call for ultimate expansion
of catastrophe data reporting beyond Europe to other regions outside the
The shareholders of the company are major insurance and reinsurance
companies and a reinsurance intermediary, ensuring that a large segment of
catastrophe loss data will be provided to PERILS. The information is
provided anonymously by insurance companies and includes exposure data
(expressed as sums insured) by CRESTA zone and by country, property
premium data by country, and catastrophic event loss data by CRESTA zone
and by country.
The data is aggregated and extrapolated to the whole insurance
industry based primarily on known premium volumes. Industry
exposure and catastrophe loss data are examined for reasonableness and
tested against information from other sources. The methodology is still
In December 2009, PERILS launched an industry loss index service for
European windstorm catastrophic events. The data can be used for industry
loss warranties (ILW) and broader insurance-linked securities (ILS) transactions
involving the use of industry losses as a trigger. Table 5.2 provides a
description of the PERILS indexes for ILS transactions.
ILW reinsurance transactions based on a PERILS catastrophe loss index
have been done shortly after the introduction of the indexes. The scope and
number of the indexes are expected to grow. The data collected by PERILS
will allow the company to create customised indexes for bespoke transactions.
The reporting is done in euros as opposed to US dollars.
Swiss Re and Munich Re indexesThe two largest reinsurance companies, Swiss Re and Munich Re, have been
compiling industry loss estimates for catastrophic events for decades. Swiss
Re’s sigma, in particular, has been compiling very reliable loss estimates for
catastrophe events worldwide, including manmade catastrophes. Munich
Re has assembled a very large inventory of catastrophic events in its
NatCatSERVICE loss database. It is similar to Swiss Re’s sigma in its broad
scope but does not include manmade catastrophes. Economic losses from
catastrophic events are often estimated in addition to the insured losses.
ILW transactions have been performed based on both Swiss Re’s sigma and
Munich Re’s NatCatSERVICE.
It is likely that for the windstorm peril Swiss Re’s and Munich Re’s estimates
are not going to be used for ILS transactions, since PERILS provides a
credible independent alternative. Other perils, and other regions around the
world usually do not have such an alternative, and it is likely that Swiss Re
and Munich Re indexes will continue to be used in structuring ILW and
other transactions. This practice may change in the future if PERILS implements
its ambitious expansion plans.
CME hurricane indexThis index has been developed specifically to facilitate catastrophe derivative
trading. The index, based purely on the physical characteristics of a
hurricane event, aims to provide a measure of insured losses without the use
of any actual loss data such as reported industry losses. While the index has been developed
for North Atlantic hurricanes, in theory the same or a similar approach can
be used for cyclone events elsewhere.
Mortality and longevity indexesA number of indexes tracking population mortality or longevity have been
developed for the express purpose of structuring derivative transactions.
These indexes are usually based on general population mortality as opposed
to that of the insured segment of the population. They can be used for
managing the risk of catastrophic mortality jumps affecting insurance
companies, or the longevity risk affecting pension funds, annuity product
providers and governments.
The CME hurricane index (CHI) was originally developed by reinsurance
broker Carvill and is still usually referred to as the Carvill index. CME Group
currently owns all rights to it.
The standard Saffir–Simpson hurricane scale is discrete and provides
only five values (from 1 to 5) based on hurricane sustained speed. Having
only five values can be seen as lacking in precision required for more accurate
estimation of potential losses. In addition, the Saffir–Simpson scale
does not differentiate between hurricanes of different sizes as measured by
the radius of the hurricane. Hurricane size can have a significant effect on
the resultant insurance losses. CHI attempts to improve on the
Saffir–Simpson scale by providing a continuous (as opposed to discrete)
measure of sustained wind speeds and by incorporating the hurricane size
in the calculation. The following formula is used for calculating CHI
hurricane-force winds extend from the centre of the hurricane. The denominators
in the ratios are the reference values. V0 is equal to 74 m.p.h., which
is the threshold between a tropical storm and a hurricane as defined by the
Saffir–Simpson scale used by the National Oceanic and Atmospheric
Administration (NOAA) of the US Department of Commerce. The index is
used only for hurricane-force wind speeds, that is, for V equal to or greater
than 74 m.p.h. R0 is equal to 60 miles, which is a somewhat arbitrarily
chosen value intended to represent the radius of an average hurricane in the North Atlantic.
EQECAT is the current official calculation agent of the CHI for CME
Group. In calculating the value of the index used for contract settlement,
EQECAT utilises official data from NOAA. If some of the data is missing,
which would likely involve the radius of hurricane-force winds, EQECAT is
to use its best efforts to estimate the missing values. There are additional
rules governing the determination of which of the public advisories (from
NOAA) is to be used, what constitutes a hurricane landfall, and how
multiple landfalls of the same hurricane are treated.
There is also an index tracking mortality of a specific group of individuals
who have settled their life insurance policies, as opposed to the mortality of
the general population. Life-settlement mortality tracked by such an index
is very different from and not to be confused with mortality of the insured
segment of the population.
This article focuses on non-life insurance derivatives and ILWs.
Mortality and longevity indexes and the insurance derivative products
based on them are described in detail in the chapters dealing with securitised
life insurance risk and the hedging of longevity risk.
MODELLING INDUSTRY LOSSESModelling losses for the whole industry is performed using the tools that are
used for modelling losses for a portfolio of risks. Industry loss estimates are
significantly more stable than those of underwriting portfolios of individual
insurance companies. Data such as premium volume provides additional
information that assists in making better predictions.
In addition, using probabilistic estimates of industry losses is a natural way of comparing
different modelling tools. An outlier would be quickly noticed and need to
be explained. Expected annual losses for peak hazards produced by
different modelling tools do not significantly diverge. The overall probability
distributions, however, can differ considerably.
As an example, the following table shows estimated probabilities of insurance
industry losses, as would be calculated by PCS, from a single catastrophic
event exceeding a certain level that is used as trigger for catastrophe
derivatives and industry loss warranties. The probabilities do not correspond
directly to the results of any of the standard catastrophe models. The
assumption based on significantly heightened hurricane activity and warm
sea surface temperature is used instead of utilising the entire historical event
catalogue. This explains the higher than usually assumed probabilities of
THE ILW MARKETThe ILW market is very similar to the traditional reinsurance market in that
it is facilitated, almost exclusively, by reinsurance brokers. The three largest
reinsurance brokers, Aon Re, Guy Carpenter and Willis Re, account for
almost all of the market volume. There are several small brokers that participate
in the ILW market, but their share is small. Investment banks, despite
their role in ILS markets in general, have limited involvement in ILWs.
The vast majority of ILWs provide protection against standard risks of
wind damage and earthquakes in the US, wind in Europe and earthquakes
in Japan. All natural perils coverage for all of these territories is also
common. The US territory can be split into several pieces, of which Florida
has the most significant exposure to hurricane risk. In addition, second- and
third-event contracts are often quoted.
For these perils, in the US the standard
index is PCS losses, with trigger points ranging from as low as US$5
billion in industry losses to as high as US$120 billion or even greater to
provide protection against truly catastrophic losses.
Figure 5.1, opposite, illustrates indicative pricing for 12-month ILWs
covering the wind and flood risk in all of the US. The prices, expressed as a
percentage of the limit, are shown for first-event contracts at four trigger
levels: US$20 billion, US$30 billion, US$40 billion and US$50 billion. The
trigger levels are chosen to correspond to those used later in the chapter in
the illustration of price levels for the IFEX contracts covering substantially
the same catastrophe events.
The prices can be seen to fluctuate dramatically depending on the market
conditions. The highest levels were achieved following the Katrina–Rita–
Wilma hurricane season of 2005. Another spike followed the 2008 hurricane
losses combined with the capital depletion due to the financial crisis. The
expectations of even higher rates immediately before the hurricane season
of 2009, however, did not materialise.
Structuring an ILWIndustry loss warranties have become largely standardised in terms of their
typical provisions and legal documentation. A common ILW agreement will
be structured to provide protection in case of catastrophic losses due to a
natural catastrophe such as a hurricane or an earthquake.
The first step will be deciding on the appropriate index, which in the US
can be a PCS index. Once the index is chosen, the attachment point has to be
determined, as well as the protection limit.
As the value of losses from a
catastrophic event is not immediately known and an organisation such as
PCS will need time to provide a reliable estimate, a reporting period needs
to be specified to allow for loss development. This period can be, for
example, 24 months from the date of the loss or 18 months from end of the
The contract risk term is generally 12 months or shorter. Some
ILWs provide protection only during the hurricane season. For earthquake
protection, the 12-month term is standard. Multi-year contracts are rare.
As an example of the legal language in a contract providing protection
against catastrophic losses due to an earthquake, the contract might “indemnify
the Reinsured for all losses, arising from earthquake and fire following
such earthquake, in respect of all policies and/or contracts of insurance
and/or reinsurance, including workers’ compensation business written or
assumed by the Reinsured, occurring within the territorial scope hereon.
This Reinsurance is to pay in the event of an Insured Market Loss for property
business arising out of the same event being equal to or greater than US$20 billion (a ‘Qualifying Event’). For purposes of determining the
Insured Market Loss, the parties hereto shall rely on the figures published
by the Property Claim Services (PCS) unit of the Insurance Services Office.”
The US$20 billion is specified as an example of the trigger level.
The limits can be specified in the manner typical of an excess-of-loss reinsurance
contract, with the possible contract language stipulating that the
reinsured will be paid up to a certain US dollar amount for “ultimate net loss
each and every loss and/or series thereof arising out of a Qualifying Event
in excess of” an agreed-upon “ultimate net loss each and every loss and/or
series thereof arising out of a Qualifying Event”.
A reinstatement provision
usually would not be included, but there are other ways to assure continuing
protection after a loss event, including purchasing second- or
multiple-event coverage, which can also be in the form of an ILW.
While the reinsurance agreement requires that both conditions be satisfied
– that is, only actual losses be reimbursed and only when the industry
losses exceed a predetermined threshold – the agreements tend to be structured
so that only the latter condition determines the payout.
The attachment point for the UNL is generally chosen at a very low level,
ensuring that exceeding the industry loss trigger level will happen only if
the reinsured suffers significant losses. There is, however, a chance of the
contract being triggered but the covered UNL being below the full reinsurance
Arguably the most important element of an ILW contract is the price paid
for the protection provided. The price would typically be expressed as rate
on line (RoL), that is, the ratio of the protection cost (premium) to the protection
limit provided. The payment is often made upfront by the buyer of the
An important issue in structuring an ILW is management of credit risk.
This topic is covered later in the chapter. Collateralisation, either full or
partial, might be required to assure payment. The need for collateralisation
is more important when the protection is provided by investors as opposed
to a rated reinsurance company.
ISDA US WIND SWAP CONFIRMATION TEMPLATEIn 2009, the International Swaps and Derivatives Association (ISDA)
published a swap confirmation template to facilitate and standardise the
documentation of natural-catastrophe swaps referencing US wind events.
Prior to that, several templates existed in the marketplace. The ISDA
template is based on the one originally developed by Swiss Re. The template
uses PCS estimates for insurance industry loss data for catastrophic wind
events affecting the US.
The covered territory is defined as all of the US,
including the District of Columbia, Puerto Rico and US Virgin Islands. The
option of choosing a subset of this territory also exists. It allows the choice
of three types of covered event: USA Wind Event 1, USA Wind Event 2 and
USA Wind Event 3. The first type is the broadest and includes all wind
events that would be included in the PCS Loss Report.
The second specifically
excludes named tropical storms, typhoons and hurricanes, while the
third includes only named tropical storms, typhoons and hurricanes. As in
all of the swap confirmations used in the past for US wind, flood following
covered perils is included in the damage calculation. The template clarifies
the treatment of workers’ compensation losses, and whether loss-adjustment
expenses related to such losses are included.
It allows for both binary
and non-binary (linear) payments in the event of a covered loss.
The ISDA template specifically states that the transaction is not a contract
of insurance and that there is no insurable loss requirement. The structure is
that of a pure financial derivative without any insurance component.
While the template brings legal documentation standardisation to these
OTC transactions, it allows a significant degree of customisation to minimise
the basis risk of the hedging party; this degree of customisation is not
possible when using only exchange-traded instruments.
IFEX CATASTROPHE DERIVATIVESOf the exchange-traded catastrophe derivatives, IFEX event-linked futures
(ELF) are one of the two most common, the other being CME catastrophe
derivatives. IFEX is the Insurance Futures Exchange, which developed
(together with Deutsche Bank) event-linked futures. IFEX event-linked
futures are traded on the Chicago Climate Futures Exchange (CCFE), a relatively
new exchange focused on environmental financial instruments.
CCFE is owned by Climate Exchange PLC, a UK publicly traded company. The
founder of CCFE, Richard L. Sandor, played a key role in the introduction
of the first catastrophe derivative products in the early 1990s. Even though
the products were well designed, at the time the insurance industry was not
ready for such a radical innovation as trading insurance risk.
In addition to the need for education, the industry then did not have proper tools to quantify
catastrophe risk or to estimate the level of basis risk created by the use
of index-linked products as opposed to traditional reinsurance.
The CCFE IFEX contracts have been designed to replicate, as far as
possible, the better-known and accepted ILW contracts.
The two primary differences between a traditional ILW and the corresponding IFEX contract
are, first, that IFEX event-linked futures are financial derivatives and not
reinsurance, and, second, that IFEX contracts provide an effective way to
minimise if not eliminate the counterparty credit risk present in many ILW
transactions. The terms “IFEX contract” and “ELF contract” are often used