Indexation Clause in Reinsurance Policies

A reinsurance contract between a ceding insurer as well as a reinsurer can last for a long period of time. A lot of the time, claims are not paid immediately. Instead, claims are paid over a long period of time. Such types of claims are called “long-tailed claims”. The problem here is that the reinsurance company pays a nominal amount in the form of a claim to the ceding insurer. However, due to rising inflation, the ceding insurer receives a lesser amount in real money terms.

Insurance and reinsurance companies in many parts of the world have realized that inflation can be problematic and unpredictable. It favors the ceding insurers sometimes while also preferring the reinsurers some other times. It is for this reason that they have tried to introduce the indexation clause in reinsurance policies.

The indexation clause is also known as the stability clause in some parts of the world since the purpose of this clause is to stabilize the payouts made by the reinsurer to the insurance company.

What is an Indexation Clause?

Every reinsurance policy has some monetary limits. For instance, reinsurance policies have a reinsurance limit. This is the maximum amount of claim that they can pay on a policy. It also has a retention limit i.e., this is the limit till which the ceding insurer is expected to bear the losses themselves. Once this limit has been breached, the ceding insurer can claim for reinsurance.

Now, the problem is that if a reinsurance contract continues for many years, then the limits on these policies do not change in nominal terms. However, their value keeps on reducing in real terms. In order to avoid this situation, both parties can choose to index these values.

Indexation means that both parties do not have to keep these values static. Instead, they can change these values dynamically based on the market condition. Both parties need to agree upon an external measure that they agree to be a barometer for inflation. In most cases, inflation numbers announced by the governments are used as an index.

Most reinsurance contracts around the world now have indexation clauses because of which these values end up changing automatically. It is important to note that the United States of America is probably the only developed insurance market in the world, where indexation clauses are not common. However, rising medical inflation is making the settlement of claims to become more expensive and prompting some insurers to include indexation clauses in their contracts.

Variations of The Indexation Clause

There are several variations of indexation clauses that are already available in the marketplace. The most common variations have been mentioned below:

  • The most common variation of the indexation clause is when both the retention limit as well as the reinsurance limit are adjusted using the same factor. This means that if an adjustment is made by 5%, both the limits are adjusted by 5%. This type of contract maintains the status quo i.e. it is impartial and benefits both parties in a similar fashion

  • When reinsurance companies have an upper hand in negotiations, they include the indexation clause only for the retention limit but not for the reinsurance limit. It is also possible that the retention limit will grow at a faster rate as compared to the reinsurance limit.

    For instance, if the retention limit grows by 5%, then the retention limit grows by 2%. This arrangement favors the reinsurance company to a large extent. This is because the maximum amount of money that will be paid by reinsurance remains the same. At the same time, the limit after which the reinsurance can be claimed keeps on increasing every year. Hence, over a period of time, more and more claims will have to be borne by the ceding insurer themselves and fewer will be passed on to reinsurance.

  • It is also possible that the ceding insurance company has an upper hand in negotiations. In such a situation, they are likely to do the exact opposite of what has been mentioned above. This means that the rate at which the reinsurance limit grows is faster than that of the retention limit. Hence, with the rise in inflation, the ceding insurer pays fewer and fewer claims in nominal terms. Most of the claims are passed on to the reinsurer who has to pay because the limits keep increasing every year

  • A fourth variation of the indexation clause is meant to ensure that the reinsurance and retention limits do not change because of small inflation movements. In this variation, there is a cut-off point. This means that if the inflation stays below that point, then the limits of the reinsurance contracts will not be reset. However, if the inflation increases beyond that point, then the limits will reset.

    For instance, if inflation is less than 3%, then there will not be any impact on the limits. However, if the inflation is more than 3%, then one or both of the limits will reset in the agreed-upon proportion.

The bottom line is that inflation can significantly change the real value of an insurance contract. As a result, it is desirable and even necessary to have an indexation clause in the contract which ensures that the real pay-outs remain fair to both parties depending upon the manner in which the contract was structured.

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