Reinsurance Policy Coverage: Advanced Scenarios

In the previous article, we have already seen that the scope of coverage of reinsurance policies can become quite complicated and open to interpretation. We now know that reinsurance policies are covered under three main different terms and conditions. However, over the years, there have been some complications have arisen in these different types of coverage. These complications have led to the creation of different variations of reinsurance policy coverage.

In this article, we will have a closer look at the various advanced scenarios which commonly arise in the process of reinsurance as well as the steps which are taken.

Interlocking Clause

The interlocking clause has been created to assist with the complications which arise when reinsurers reinsure policies based on a “risk attaching” basis. For reinsurance policies that were written on a risk-attaching basis, the period when the loss occurred is not important. Instead, the date on which the policy was issued is important.

For example, let’s assume that an insurance company has issued two motor insurance policies. One policy has been issued in 2020 whereas the other has been issued in 2021. Now, in the year 2022, the claim has arisen since there has been heavy flooding and both cars have been destroyed. Now, the date of the actual loss i.e. 2022 is irrelevant. The date on which the policies were issued i.e. the years 2020 and 2021 are considered important. Since they fall under two different policy years, two separate policies will apply for the same.

Now, the problem is that each reinsurance policy generally has a deductible. For example, the reinsurance policy only pays claims above $1 million. Now, the problem in the above-mentioned case is that the claim which arises from the same event will be split into two different years. Hence, the deductible limit of $1 million dollar will apply twice.

Let’s say that the total loss from both years is $1.5 million with 50% of the losses arising from policies underwritten in 2020 and the other 50% of the losses arising from policies underwritten in 2021. This means that in each of the policy years, the insurance company has faced a loss of $750,000. Since this is less than the deductible amount of $1 million, the reinsurance company might not pay even a single dollar even though the insurance company has lost $1.5 million from a single event!

In order to prevent such situations, the interlocking clause is included in many insurance contracts. The interlocking clause ensures that if the loss is arising from the same event, then the deductible amount is prorated.

This means that since both 2020 and 2021 contribute to 50% of the losses, the deductible amount in both years will be scaled down. This means that the $1 million deductible amount which was being considered earlier will be reduced to $500,000 for both years. Now, the reinsurer will have to make sure that they pay the claim which is in excess of $500,000 for each year.

In this hypothetical case, the claim is $750,000 for each year. Hence, the reinsurer will deduct $500,000 from each year. This means that they will pay $750,000 minus $500,000 which is $250,000 for each year. As a result, the insured will end up receiving a total claim of $500,000 because of the interlocking clause as opposed to $0 without it.

It is for this reason that insurance, as well as reinsurance companies, need to be aware of whether the interlocking clause is present in their policy so that they truly understand the coverage which they have.

Hybrids

Many times insurance companies are not satisfied with any one type of coverage. In such cases, it is common for insurance companies to negotiate with their reinsurance company and come up with a hybrid policy. One such hybrid policy which is famous is known as the runoff policy. This generally happens in the case of termination of the contract via any one of the parties.

It is common for insurance companies to have a reinsurance policy with “losses occurring during” coverage. However, if the policy is abruptly stopped, then the reinsurer will still be liable to make the claims of the existing policies for a certain predefined amount of time. In this case, the reinsurance policy essentially switches from a “losses occurring during” policy to a “risk attached during” policy.

There are several other such hybrids that are used by different insurance and reinsurance companies as per their own needs. The only problem with hybrid models is that it provides some specific options to one of the parties. Now, finding out the financial value of such options and including them in the contract pricing can be quite challenging. This is the reason why the pricing of hybrid reinsurance contracts is considered to be a tough task.

The bottom line is that the reinsurance industry is rapidly evolving. As such, the types of policies being offered as well as the specific coverage which they provide are also evolving at a fast pace. The hybrid coverage reinsurance policies are the result of this innovation and are likely to continue in the future.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.