Reinsurance Tutorials #7 - Season 2
Hi everybody 👋
Most of the time, an Excess of Loss treaty is used to cover motor business.
The treaty covers both Motor Physical Damage (including casualty and collision) and Motor Third Party Liability. Motor Third Party Liability coverage provides compensation for both property damage and bodily injury damage suffered by a third party. Compensation for bodily injury damage, specifically severe bodily injury damage, is provided after long periods, sometimes many years and even decades.
Because of this, Motor is considered long-tail business.
Some clauses are especially drafted to meet with the specific criteria of Motor Excess of Loss treaties. We will focus on two of these clauses: the Indexation clause and the Annuities clause.
Let’s start with the Indexation clause! ⏬
The Indexation clause
Motor treaties are written on a loss occurring basis. Therefore, the Reinsurer pays claims that occur within the period of effect of the treaty many years after occurrence of the loss.
Consequently, much time may pass between the underwriting year and the period of claims payment or settlement and the treaty deductible and limit suffer inflation or monetary erosion. This can modify the Reinsurer’s liability as the deductible and the limit initially negotiated and agreed upon at the time of underwriting no longer have the same impact.
In order neutralize this effect, long tail treaties include an indexation clause. In this clause, the Reinsurer and the Cedent express their intention to retain the relative value of the deductible and the limit of liability agreed under the treaty.
They also agree that their respective contribution in the payment of the losses remains in force at the date of reference mentioned in the treaty. The indexation clause defines a reference index which is applied to the deductible and the limit of the Reinsurance agreement. This Reference index or Base index is most often an income index, or a consumer index.
The Base index at the underwriting year is stated at index 100. Each loss settlement or payment (lump sum or annuities) made under the Reinsurance agreement will be adjusted using this Base index value.
Let’s look at an example.
A Motor bodily injury claim occurs in 2016. The claim triggers an excess of loss of 1,000,000 euros in the 2016 treaty. In 2021, the loss is estimated at 2,000,000 euros. The Cedent which had already paid 1,000,000 euros to the claimant, requests payment from its Reinsurers.
Should the Reinsurers pay an additional 1,000,000 euros? Yes, if there is no Index Clause. No, if there is an Index Clause.
The deductible (or retention) of the treaty, which is 1,000,000 euros, must be recalculated according to variations in the Base Index Clause. If the Base Index was stated at 100 and has increased to 102 in the period from 2016 to 2021, the priority is no longer 1,000,000 euros but 1,020,000 euros. Then, the Reinsurers will pay 980,000 euros and not 1,000,000 euros.
There is a variant of this type of Index Clause. It is called the Full Index Clause.
This clause may, for example, be only applied when there is a specified percentage of variation of the Base index (in most cases 10%). Then, the Index clause is triggered only when the Base index shows a variation of over 10%. If so, the applicable deductible and the Reinsurer’s liability shall be increased or reduced proportionally. If not, the deductible and the limit are the fixed amounts agreed in the treaty.
Quite fair, no?
The Annuities clause
The second specific clause used in Motor Bodily Injury treaties that I would like to share with you is the Annuities clause. What is an Annuities clause? This clause is specific to some markets and quite popular on the French market.
A bodily injury may be compensated for by payment of a lump sum or annuities (called Periodical Payment Order in the UK). When an annuity or a PPO is settled, the Annuities clause defines the Reinsurer’s liability.
There are two kinds of clauses:
- “Annuities Follow-up” clause: the Reinsurer follows the fortune of the Ceding company until the end of the annuity. With an additional method, the Reinsurer also pays the total of the stabilized paid annuities above the deductible. The Reinsurer must consequently keep the file open as long as the claimant is alive
- “Annuities Buy-back” clause: The Reinsurer pays all the discounted future cash flows in one shot with a lump sum. All calculation rules are defined in the treaty. The payment frees the Reinsurer (except when cases are reopened as mentioned in the treaty).
Any “Annuities Buy-back” clause must mention the future features to be taken into account in order to calculate the lump sum paid by the Reinsurer: mortality table, discount rate and date of calculation.
See you soon in the next video with Clémence who will take a close look at the French market...
Bye for now 👋
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