Protect against Inflation with the Reinsurance Index Clause
December 2010
Because many insurance claims take years to
be settled or adjudicated, inflation tends to increase the cost of these long-tail
claims to insurance and reinsurance companies.
by Larry
P. Schiffer *
Dewey & LeBoeuf
LLP
Inflation on claim payments often adversely affects the economics between
the parties to a reinsurance contract by increasing the overall loss ratio and
affecting the original assumptions made by the parties when the reinsurance
premiums were first negotiated. The impact of inflation is most significant
in excess-of-loss reinsurance contracts where the agreement expresses the ceding
insurer's retention and the reinsurance limit in fixed dollar (or other currency)
amounts.
This article discusses how European reinsurers have addressed the inflation
issue by incorporating into their reinsurance contracts something called an
"index clause."
What Is an Index Clause?
An index clause is a specialized clause that distributes the effects of inflation
on claims costs, which tend to fall on the reinsurer, between the ceding insurer
and the reinsurer. It is used most frequently in excess-of-loss reinsurance
contracts covering long-tail risks.
European reinsurance contracts began incorporating index clauses heavily
in the 1970s to distribute the impact of inflation between ceding insurers and
reinsurers. Today, European ceding insurers use the index clause fairly consistently
in excess-of-loss reinsurance contracts covering motor liability, general liability,
and professional liability risks.
Despite the prevalence of index clauses in European reinsurance contracts,
companies in the United States do not appear to have adopted this clause to
protect against inflation. Instead, United States-based companies have used
other methods to protect against inflation.
How Does the Index Clause Work?
An index clause, also referred to as an inflation clause, a stability clause,
or an indexation clause, redistributes inflation-related increases in the costs
of claims between the ceding insurer and its reinsurer. In most excess-of-loss
contracts, the ceding insurer's retention and the reinsurance limit amounts
are fixed dollar (or other currency) amounts, and the reinsurer's liability
triggers at the point the retention is met. If neither the retention nor the
limit is indexed, claim inflation can cause a loss to reach the retention amount
sooner and more frequently than anticipated. Further, if there is greater inflation
after the claim reaches the retention amount, the reinsurer's liability will
not increase with the rising cost of the claim. The index clause achieves redistribution
of these inflation-related increases by adjusting the retention and limit amounts
of a reinsurance contract in accordance with an inflation index.
For excess-of-loss treaties, index clauses are particularly useful where
the underlying losses take a long time to be paid. There is a direct relationship
between the cost of claims settlements and increases in costs due to inflation
and economic growth. For example, in liability claims there may be a longer
delay between the dates the claims are reported and the dates the claims are
finally settled or adjudicated when compared to many property claims. Thus,
liability claim settlements in particular typically will experience a greater
increase in costs over the lifecycle of the claim due to inflation rates.
The value of an index clause is therefore apparent in situations where inflation
causes the cost of the claims to reach and exceed the retention amount sooner
and more frequently than anticipated by a reinsurer. Because the index clause
redistributes this effect of inflation, its application in a reinsurance contract
usually works in favor of the reinsurer.
But an index clause may work in favor of a ceding insurer in situations where
the reinsurance limit is indexed, but the retention is not subject to an inflation-related
adjustment. This arrangement, however, places the burden of inflation even more
explicitly on the reinsurer, and the reinsurer may not agree to this application
of the index clause unless the retention is set sufficiently high so as to decrease
the likelihood of the cost of the claim exceeding the retention amount other
than in a catastrophic situation.
Despite the prevalence of index clauses in excess-of-loss treaties, they
do not appear in proportional treaties likely due to the nature of proportional
treaties themselves. In proportional treaties, the ceding insurer and the reinsurer
share the premiums and losses on a percentage basis, and thus the burden of
inflation appears to fall on both parties ratably.
Using Contract Wording To Describe Index Clause Variations
As reinsurance markets began to adopt the use of index clauses, index clauses
began to take various forms. The most basic type of index clause maintains the
originally intended proportions between the retention and limit amounts in a
reinsurance contract. Below is an example of a clause that simultaneously adjusts
both the retention and limit amounts in a reinsurance contract (Robert W. Strain,
Reinsurance Contract Wording):
The amount of the Company's retention and the Reinsurer's limit shall be
adjusted annually as respects loss settlements resulting from occurrences
with a date of loss on and after [the agreed upon date], so as to equitably
share the effect of deflation and inflation between the Company and the
Reinsurer.
This index clause accounts both for increases and decreases in the cost of
claims due to inflation. Here, the index clause automatically resets the retention
and limit amounts annually without both parties having to revisit the terms
of reinsurance coverage.
While the index clause illustrated above applies to both the retention and
limit amounts of a reinsurance contract, some index clauses may apply only to
a contract's retention amount. In this version of an index clause, the reinsurer
gives a fixed amount of reinsurance coverage in excess of the indexed retention.
Thus, while the retention may fluctuate due to inflation, the reinsurer will
pay a fixed amount of reinsurance cover regardless. A variation on this type
of index clause is when the retention is indexed, but not the upper limit of
the reinsurance contract. Here, if claims are affected by inflation, the reinsurer
will pay less and less over time (R.L. Carter,
Reinsurance).
An index clause in a reinsurance contract can also trigger at different points
of a claim. A predominant type of index clause used by European ceding insurers
is the London Market Indexation Clause (LMIC). This excerpt of the LMIC shows
how this particular index clause applies at different points depending on the
nature of the payment:
In respect of any loss settlement(s) . . . made under this Agreement, the
Reinsured shall submit a list of payments comprising such loss settlement(s)
showing the Amount(s) of Payment and the Date(s) of Payment. All payments
made by the Reinsured in respect of a Bodily Injury claim relating to a
Claimant, including the Claimant's legal costs and legal costs incurred
by the Reinsured in the defense of a claim, shall be aggregated and the
index value used shall be that for the period embracing the Date of Payment,
as defined below.
The definition of "Date of Payment" in the LMIC, and, therefore, the point
at which the index applies, varies depending on whether the payment was received
in a settlement or by a court judgment or whether the payment is received as
a lump sum or in periodic settlements.
The final common application of an index clause is where the index triggers
after the inflation rate has passed a certain percentage of inflation over the
original amount. In some clauses, any increase in the cost of the claim less
than the specified percentage is ignored, but the index clause provisions operate
in full after the claim reaches that percentage (Swiss Re,
Non-Proportional Reinsurance Accounting):
If the reinsured makes payments for losses which are covered by this treaty,
the reinsured shall send the reinsurer a list of the individual losses settled
with the corresponding payment dates. The amount of each individual loss
shall be adjusted using a formula agreed upon by the reinsured and the reinsurer.
However, this adjustment shall only be carried out if deviations of more
than 10 percent occur between the base index and the index at the time of
payment. Otherwise the actual amount of the payment shall apply.
The base index and the index at the time of payment in this clause must exceed
10 percent for the index clause to be triggered. This type of index clause is
also called the franchise inflation clause. (Reinsurance
Pricing: Practical Issues & Considerations, Sept. 8, 2006.) The percent
of deviation also can vary below or above that 10 percent figure.
Under a similar type of inflation clause–the severe inflation clause—the
index clause adjustments apply only after there is a certain percentage of inflation
per year. Once that threshold is breached, however, the inflation amount of
the claim applies only in excess of the agreed upon percentage.
Conclusion
In its development, the index clause has taken many variations, but the basic
purpose of the index clause remains constant. The index clause is instrumental
in preserving the spread of liabilities and risks for both the ceding insurer
and its reinsurer. Despite the index clause's ability to account for inflation-related
increases in the cost of claims, it is interesting that companies based in the
United States have not adopted the use of this clause in excess-of-loss reinsurance
contracts.
Medical inflation continues to rise at an alarming rate in spite of the current
low rate of economic inflation. This may prompt companies in the United States
to consider the index clause a useful tool to protect against inflation-related
fluctuations in the costs of long-tail claims.
*
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