Aggregate Extension Clause (AEC): An Overview
An aggregate extension clause (AEC) in a reinsurance contract permits a single claim for numerous small losses of a similar nature. The clause generally covers reimbursement of a specific category of losses that exceed a stated amount.
For example, say a glass manufacturer estimates its annual losses due to breakage in the factory as 1% of its production total, or $1,000 a year. The aggregate extension clause would provide reimbursement for losses due to breakage that exceed $1,000. The business is not required to document every instance of breakage.
Understanding the Aggregate Extension Clause (AEC)
An aggregate extension clause may be used to cover any known risk that can be expected to occur frequently. Each incident has a trivial financial impact but added together they are significant.
The use of such clauses first appeared in the London reinsurance market as early as the 1940s.
It acknowledges that documenting each minor incident would be cumbersome if not impossible. Instead, the business budget anticipates an estimated loss and insurance may be sought to cover the same risk at an unanticipated level.
The aggregate extension clause estimates the frequency of occurrence for such low-impact events within a set time frame and aggregates them in order to arrive at a dollar amount for reinsurance.
Insurance and Reinsurance
Insurance companies insure their own risks by buying reinsurance policies. Such agreements are also called reinsurance treaties.
A specific type of reinsurance treaty called an excess of loss reinsurance treaty protects against the risk that an insurer will have to bear the costs of losses that are far more severe than it anticipated.
When an aggregate extension clause is stated in a reinsurance policy, the underlying insurance policy will carry the same terms, using the same standard language.
- An aggregate extension clause allows for reimbursement of a single claim for losses that were caused by a number of similar incidents.
- It is typically used for reinsurance of a business that has identified a specific known risk of damage or loss.
- The aggregate extension clause generally allows for reimbursement of losses that exceed a specific amount.
Use of AEC With Excess of Loss Reinsurance
Excess of loss reinsurance provides coverage for individual losses exceeding a specific loss retention amount. Losses below the loss retention amount are the responsibility of the ceding company or the company that bought the excess loss reinsurance. However, losses above the retention amount are the responsibility of the reinsurer.
The reinsurer limits its risk with caps written into the contract at a specific limit.
Reinsurance companies provide insurance companies with protection from excess losses.
Excess of loss reinsurance treaties work well when the underlying insurance contract deals with losses on a per-occurrence basis. When the underlying insurance contract deals with losses in the aggregate, excess of loss reinsurance treaties can run into problems.
Reinsurance is designed to provide coverage for losses above the ceding company's retention on a per-occurrence basis. Reinsuring against aggregate losses is complicated since the per occurrence loss is typically lower than the ceding company's retention level. The reinsurance contract may add an aggregate extensions clause (AEC) to deal with losses in aggregate.
Example of Aggregate Extension Clause
A manufacturer produces hundreds of thousands of boxes of frozen meals each year. Each meal produced carries a small liability risk because the packaging can get damaged, rendering the product unsaleable.
The manufacturer buys a product liability policy to protect against the loss. The liability policy protects the manufacturer from losses above a specific limit on an aggregate basis rather than on a per-occurrence basis.
The underwriter to the liability policy, in turn, buys an excess of loss reinsurance policy with an aggregate extension clause to protect itself from paying the manufacturer if the amount of claims exceeds the underlying policy's retention limit.