Markets should make adjustments to bring indexation clauses into line with the actual development of claims, argues Scott Altstadt.
Inflation rates threaten long-tail reserves and reinsurance price stability. A loss inflation deterioration of 2% per year in a motor excess of loss reinsurance programme could generate an annual price increase of more than 30%. This, however, needn’t materialise.
Indexation clauses and the specific indices used within these clauses define the cedant-reinsurer “who pays” and “how much” relating to claims inflation.
By adjusting these clauses to correspond better to actual claims inflation – after analysing claim cost components – indexation clauses can equitably share inflation risk, mitigate reinsurance price increases and give all parties a more stable reserving platform.
So what needs to change? Although the choice of indexation clause (mainly either Full, Franchise or Severe) affects how inflation is ultimately shared, a key consideration is the choice of “proxy index” – the index applied to paid losses, usually the CPI or Wages index – defined within the clause. If there is a significant gap between the proxy index and actual claims inflation, the purpose of the indexation clause is lost.
“Adjusting these clauses can achieve equitable sharing of inflation risk.
In some western European markets, inflation for large bodily injury claims is more than 10% while the CPI/Wages index is about 4%. The economic index under-estimates actual claims inflation because it has a disproportionately smaller medical cost component than large bodily injury claims. By using it as the proxy index, inflationary risk is shifted to the reinsurer.
To bring indexation clauses in such markets into line with actual claims inflation, insurers could switch to an indexation clause with the CPI/ Wages index, but with a given percentage of additional inflation.
Scott Altstadt is chief pricing actuary, property and casualty, at PartnerRe.