Parametric structures minimise or eliminate limitations of ILWs: Skyline Partners

Industry loss warranties (ILWs) remain a useful and well-established instrument within the capital management toolbox of risk carriers, but do have their drawbacks, some of which can be mitigated or removed entirely by a parametric structure, according to Skyline Partners.

As parametric insurance, reinsurance, and retrocession structures continue to grow in popularity, Artemis spoke with Laurent Sabatié, Co-founder and Executive Director, and Ken MacDonald, Strategic Advisor of Skyline Partners, a full-service provider in the parametric insurance supply chain.

ILWs are an indexed-based reinsurance instrument which pays out when the estimated total industry-wide insured loss arising from a specific, covered event or group of events exceeds an agreed threshold, as calculated by a third party.

They can be used to cover a dead or live cat event, and Sabatié explained are often purchased by cedants as a back-up cover to protect their balance sheets when multiple sequential events during the same storm season occur or are feared.

But while ILWs are both useful and well-established, Sabatié stressed that they’re certainly not without their limitations, including the issue of basis risk.

“They typically use market-loss data compiled by commercial entities or major reinsurers to determine when an ILW is triggered for payment. This is inherently inconsistent with any specific cedant’s actual value at risk. The inconsistency is exacerbated by reporting gaps which leave total losses underestimated or based on guesswork,” said Sabatié.

“Perhaps worse is the long wait for settlement,” he continued. “ILWs – by design – do not pay until the industry loss has settled, or at least comfortably exceeds the trigger point. The naturally long period required to calculate a reliable industry loss can, in the extreme, be many years. In the interim, the cedant may not be able even to recognise the reinsurance recovery in their P&L.”

Expanding on the limitations and issues surrounding ILWs, MacDonald highlighted both a lack of flexibility and a potential lack of transparency.

“Their structure is very rigid, with trigger conditions that take no account, for example, of variations in risk profiles across portfolios, or the evolving nature of tropical cyclone risk.

“The ILW market operates predominantly as an over-the-counter market, with limited regulatory oversight, and therefore transparency, relative to traditional reinsurance markets,” said MacDonald.

Another negative, according to Sabatié and MacDonald, include the fact the scope of the ILS coverage is limited geographically, as areas not covered by third-party industry loss collation services cannot be covered by ILW instruments.

Further, calculation of total loss is often underestimated because certain types of losses may be excluded from industry loss calculations, explained the pair.

According to Sabatié and MacDonald, the answer to these limitations with ILWs, is the parametric structure, which does share some characteristics with ILWs.

“They too can be index based, but they are triggered for payment when a specified event occurs, with no regard for the total (and irrelevant) industry loss arising from the event. They minimise or eliminate many of the issues associated with ILWs,” said Sabatié.

Starting with the basis risk issue, Sabatié told Artemis that parametric triggers can reduce basis risk as they can be designed to align very closely with the actual damages caused by an event to a specific re/insured portfolio.

“Through pre-event analysis of its exposed values and location coordinates, coverage can be designed to react with precision to relevant events, reducing basis risk substantially compared to ILWs.

“The trigger events – or “parameters” – of the index, and the loss scales created and adopted for a specific coverage contract, can each be calibrated to minimise remaining basis risk. This may apply, for example, to the intensity triggers of the index such as windspeed, days of excess temperature, or the order of the event during a coverage period. Adjustment can be used to ensure triggers align with cedant objectives regarding the attachment and/or exhaustion probability of specific economic loss tranches, as well as budget,” said Sabatié.

Adding, “This alignment ensures triggers match the modelled cat losses used in reinsurance purchasing and capital modelling. The parameters can even be optimised to align with the distribution probability of the cat losses that inform not just the overall reinsurance placement, but also the capital modelling behind it. They are, therefore, fully integrated within the purchaser’s enterprise risk management framework.

“Alignment makes the value of parametric coverage is much greater, because it focusses more accurately on the reinsured’s specific exposures, not those of the entire industry.”

Another benefit of a parametric structure is that claims settlement is extraordinary efficient, with settlement often within a calendar month of the triggering loss event.

“Reduced administrative burdens provide faster, certain access to funds underpinning liquid capital. The beneficial financial impact of parametric reinsurance can be recognised much faster,” said MacDonald.

“Settlement is much simpler than with traditional indemnity-based reinsurance, which may also be said of ILWs, but with parametric reinsurance payments are not delayed while industry-level losses are calculated and left to develop. Nor does inflation decrease the relative value of the recovery while you wait.

“This lightning speed of settlement also benefits reinsurance capital providers by eliminating trapped capital and removing concerns over loss creep,” he continued.

The flexibility of parametric structures, explained Sabatié, means that coverage can be tailored to match the risk, which ensure better pricing as cedants pay solely for protection that matches their exposure precisely.

Additionally, Sabatié noted that coverage is broader than with an ILW, as any type of economic loss with a covered event may be reimbursed by a parametric reinsurance structure, including intangible exposures such as loss of access.

“Parametric triggers are highly flexible and can be tailored to respond to parameters which precisely meet each cedant’s specific needs. Triggers may take into account factors such as geographic location, risk profile, historical incidence, and/or almost anything which can be shown to contribute to loss and quantified. Payment structures can be varied to account for changing values at risk, or future changes of conditions. Risk nuances can therefore be measured more effectively and covered more advantageously. Nor is parametric reinsurance limited to nat cat exposures. It has been used to reinsure perils ranging from cyber to marine cargo,” said Sabatié.

Commenting on some additional, major benefits of a parametric structure, MacDonald explained that, “Parametric reinsurance structures typically operate in well-established regulated markets which ensures greater transparency and oversight relative to ILWs. Insurers can therefore gain access to a broader range of potential counterparties, and benefit from the expertise and financial strength of established reinsurance players. Most of them are already active in parametric.”

He also underlined that regulated parametric products do not rely on uncertain Letters of Credit or unrated capital, which gives cedants reassurance over the reliability and stability of their reinsurance arrangements.

“With lower basis risk, better counterparties, closer alignment with modelled outcomes, and a regulated nature, parametric reinsurance qualifies as Tier 2 Capital under European solvency rules. This is in stark contrast to ILWs which are considered derivative products,” said MacDonald.

“In Parametric vs. ILW, parametric reinsurance wins on transparency, certainty, responsiveness, simplicity, speed of payment, and balance-sheet benefits. Skyline Partners, the parametric catalyser, has everything it takes to get parametric reinsurance structures designed, built, and operational. We work daily with brokers, cedants, captives, and reinsurers alike to deliver the winning parametric advantage,” concluded Sabatié and MacDonald.

It’s important to note that ILW’s and parametrics both play an important role and are well-suited to specific situations, with some protection buyers even using the structures to complement each other within their coverage arrangements.

We suspect both will continue to play these important roles, but as technology advances and use of data becomes increasingly sophisticated, the basis risk associated with them will increasingly be minimised and the structures themselves refined, with their protection honed and improved.