ILWs must be carefully defined to avoid disputes, says expert

Catastrophic events have been a major feature in the insurance industry in recent years. Earthquakes, floods and hurricanes, including Katrina in 2005 and Sandy in 2012, have caused significant losses. Losses arising from catastrophic events caused $186 billion of damage in 2012. Only in 2005 and 2011 were such losses greater.

Against this backdrop, it is no surprise that the industry is increasingly turning to ILWs. These cover a reinsured's losses arising from an event or series of events where the insured market loss exceeds an agreed threshold. Whether a claim is covered by such a particular ILW depends, to a large extent, upon the wording defining that threshold.

Organisations making use of ILWs must therefore carefully consider the definition of market wide losses and the indices against which thresholds are measured if they are to avoid expensive disputes.

That threshold will be defined in relation to a number of factors such as geography, types of loss and types of event.  For example: "A Hurricane causing insured non-marine losses in excess of US$7.5 billion anywhere in North America".

To determine whether or not losses cross a threshold a third party index of losses is used and this can be where issues arise. These indices were not designed for bespoke ILW wordings and often do not exactly match the terms of a particular threshold.

Property Claims Services (PCS) estimates are normally used for events affecting the US, whilst SIGMA is often the source for events elsewhere. Munich Re's NatCat Service and PERILS' estimates are also used.

When the indices and reinsurance trigger wording are aligned the use of such indices can be a quick and efficient manner in which to determine liability under an ILW. Indeed, it has been reported that significant settlements have been made under ILW policies very promptly. 

But when the indices and the thresholds do not match, disputes are likely, which is time-consuming and expensive. This is most likely to happen where:

• an index does not estimate losses arising from a geographical region named under the threshold. An example would be a threshold which includes losses in the Caribbean but uses an index, such as PCS, which only covers the US. As a result losses which would trigger a threshold are not captured by the index;
• an index is nominated which does not estimate losses arising from a particular type of loss named under the threshold. For example, a threshold includes all insured losses and loss adjustment expenses but uses an index, such as PCS, which does not include 'ocean marine' or loss adjustment expenses. Again, threshold trigger losses may not be captured by the index;
• an index is nominated which estimates losses arising from a particular type of loss which is excluded under the threshold.  In such circumstances, it is likely to be difficult to determine the extent of the excluded losses and whether the threshold has been fulfilled.  This is particularly so as some providers, such as SIGMA, are unwilling to provide details of their methodologies or breakdowns of particular loss event estimates;
• where two indices are nominated for different geographical areas and inconsistencies arise between their differing methodologies.  Again, the reluctance of providers to provide details of their methodologies and breakdowns can make the use of estimates unreliable in certain circumstances;
• an index combines two related events.  For example, SIGMA treats the 2001 attacks on the twin towers of the World Trade Centre as one event, whilst the parties may have determined between themselves that the attacks should be treated as two separate events. This makes it difficult to decide whether the threshold in respect of one or other event had been reached.

If a reported insured market loss is close to either side of a threshold figure then disputes are more likely to occur. The reinsurer will wish to prove that losses not falling under the terms of the threshold are part of the index figure; the reinsured will wish to demonstrate that losses falling under the threshold have not been included within the index.

Careful drafting of ILW wordings and thought when selecting indices can help to reduce the chance of disputes. If a dispute does arise then parties may wish to use a different index or other sources of information to determine the true insured market loss figure for a particular threshold.

Nicholas Bradley and Stephen Kilner are insurance and reinsurance experts at Pinsent Masons, the law firm behind Out-Law.com. A version of this article originally appeared in Insurance Day.