In the context of long-tail insurance policies, claims have an impact on reinsurance treaties and it can take years before these claims are settled.
When there is severe inflation in a country, the cost of long-tail claims borne by reinsurers will mathematically increase
An index clause – also referred to as an inflation clause – a stability clause or an indexation clause, will redistribute the effects of inflation on claims which then fall on the reinsurer, between the ceding insurer and the reinsurer.
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.
Furthermore, 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.
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 (or 14%, or whichever % agreed between the parties) occur between the base index and the index at the time of payment. Otherwise, the actual amount of the payment shall apply.
Here below is a crude example:
A reinsurance treaty – an XL treaty protecting Motor Liability – has been put into place in 2010. We are now in 2020. Claims occurred during 2010 and have been paid off over the years – they are finally settled by 2020.
Suppose the inflation over the years reached 25%. There is a base of 1 in 2010 and of 1.25 in 2020.
The XL treaty is 20m x 5m.
There has been a loss, now settled at 15m.
Faced with these figures, the reinsurer should take 10m and the Ceding party should retain 5m.
All this with an inflation of 25%. Therefore, from 1.25 to base 1, we have an unindexed loss of 12m(15m/1.25).
Because of the index clause, the reinsurer will bear 8.75m (instead of 10m) and the Ceding party will retain 6.25m (instead of 5m).
How? The loss has gone from 12m to 15m. Therefore, the unindexed loss is 12m at base 1.
If we index the priority: 5m *(15/12) = 6.25m
If we index the limit:20m*(15/12) = 25m
The reinsurer sees it as a priority and his limit will increase by 1.25.
The loss of 15m minus 6.25m leaves 8.75m to the reinsurer, and 6.25m is retained by the company.
Another method would have been to proportionally use the percentage borne by the priority with the loss at base 1:
5m/12m = 41.67%
In this case, the Ceding party takes 41.67% of the loss, while the other 58.33% go to the reinsurer.
Once again, the basic purpose of the index clause is to share – between the Ceding party and the reinsurer – the increase of the loss due to inflation as equally as possible.