This article was written for and published on IRMI.com
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. 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 commentary 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 life cycle 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 Some Variations in Index Clauses
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% (ten per cent) 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 ten 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 ten percent figure.
Under a similar type of inflation clause called 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.
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.
The author gratefully acknowledges the significant contributions to this Commentary by 2010 Dewey & LeBoeuf Summer Associate Pooja B. Faldu, presently a third-year student at Cornell Law School.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.