Aggregate Extension Clause (AEC)

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 as 1% of total factory production, or $1,000 a year. The aggregate extension clause would reimburse 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 individual incident is financially trivial, but together add up. The use of such clauses first appeared in the London reinsurance market as early as the 1940s.

Documenting each minor incident would be cumbersome if not impossible. Instead, a business would budget for anticipated losses and insurance may be sought to cover risk at an unanticipated level. The aggregate extension clause estimates the frequency of occurrence for 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 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.

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.

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 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, as 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 potential losses. 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.