In the previous article, we have already seen what an indexation clause in reinsurance contracts is. We are now aware of the purpose behind having indexation clauses in reinsurance contracts. We also know the various variations of the indexation clause which are common in the marketplace.
However, before taking a final decision on whether or not indexation clauses are helpful, it is important for any student of reinsurance to completely understand the pros and cons of the issue. In this article, we will present some of the important pros and cons of indexation clauses which can help better understand their utility.
Benefits of The Indexation Clause
An indexation clause is widely used in reinsurance contracts because it provides a lot of utility to both parties. Some of the common benefits have been listed below:
- Automatic Reset: Reinsurance contracts are negotiated with great patience. These contracts are generally entered into for the long term. Neither party generally has the intention of walking out of a reinsurance contract. Now, since the reinsurance arrangements are expected to continue for a long period of time, it is necessary for the contract to be created in such a way that it stays current even with the passage of time.
The indexation clause enables an automatic reset of the important financial limits within a reinsurance contract. This means that the negotiations do not have to take place every year and that the contract can continue to stay current in real money terms even if it goes on for a decade.
- Avoids Unnecessary Trigger of Reinsurance Policy: The reinsurance policy is generally meant to support the ceding insurer in the event of a catastrophe. This means that the retention limit is set in such a way that under normal circumstances, the reinsurer is able to manage their own claims. However, if a reinsurance contract does not contain an indexation clause, then the retention limit keeps on going lower and lower in real money terms. As a result, after a certain number of years, normal business operations will end up triggering the reinsurance policy. This will lead to an increase in the premium of reinsurance and defeat the entire purpose for which reinsurance is used.
- Encourages Faster Processing: Indexation claims ensure that the reinsurer has to pay the ceding insurer a larger nominal monetary value if they delay the claims. This means that any processing delay has a dollar value attached to the same. As a result, the reinsurer will be encouraged to create a process wherein the claims are settled at a faster speed. Hence, indexation clauses end up increasing the efficiency of the reinsurance company.
- Ignores Minor Changes: Most indexation clauses are created in such a way that they get triggered only when significant changes are detected in the inflation rate. This means that a 0.5% inflation rate will generally not cause any change in the reinsurance policy. However, a 4% inflation rate will lead to changes in retention as well as reinsurance limits. Hence, the system can be created in such a way, that minor changes are ignored and unnecessary inconvenience is avoided.
Drawbacks of Indexation Clauses
Even though indexation clauses have been appreciated by most players in the reinsurance industry, there are still several critics who point out the issues related to indexation clauses. Some of the drawbacks have been listed below:
- Regulatory Hassles: Various regulatory bodies across the world mandate reinsurance company to set aside a certain sum of money based on their projected liabilities. When reinsurance companies include indexation clauses in their contracts, their liabilities are bound to change. The revaluation of these liabilities as well as making sure that the reserves are compliant with the regulatory provisions which apply to the change liabilities can be quite a hassle. This can be time-consuming and may lead to non-compliance which can also lead to fines and penalties.
- Derivatives as an Alternative: A big argument against the use of indexation clauses is that they are redundant and add unnecessary complexity. Both parties are forced to agree on a certain benchmark that is not required. This is because well-developed derivatives markets are already available in different places across the globe.
As a result, if one party wants to hedge their inflation risk, they can simply buy a derivative as per their need. There is no need to introduce complexity in the reinsurance contract. This is said to be one of the reasons why America, which is one of the largest derivative markets in the world, is also the market where indexation clauses are very rare in reinsurance agreements.
- Basis Risk: For an indexation clause to work both parties have to agree upon a barometer. In most cases, the inflation rate declared by the government is considered to be the barometer. It is important to realize that this inflation rate, which is announced by the government, may be influenced by political considerations.
It is possible that the inflation rate may not reflect the true picture in the market. Hence, both insurance companies are reinsurance companies may end up being exposed to this basis risk that the increase in their liabilities does not correspond to the increase in the reinsurance limits.
- Increases Complexity: Indexation clauses can also be quite complex to process. This can create a lot of issues while processing premiums and claims. Reinsurance companies have to change their processes in order to accommodate the additional complexity. This is one of the reasons that lead to the criticism of indexation clauses.
The fact of the matter is that indexation clauses have their pros and cons. They need to be carefully considered to understand whether it is appropriate to add this clause to a reinsurance contract.
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