What is the Indemnification Method?

The indemnification method calculates the termination payments when a swap is ended early and the holder has accepted an offer of prepayment.

Key Takeaways

  • The indemnification method requires the at-fault counterparty to compensate the responsible counterparty for all losses and damages caused by the early termination.
  • The indemnification method calculates the termination payments when a swap is ended early and the holder has accepted an offer of prepayment.
  • Agreement value method, which is based on the terms and interest rates available for a replacement swap, is considered to be more efficient than the indemnification method for calculating termination payments.

Understanding the Indemnification Method

The term indemnity means protection against liability. Indemnification clauses are common in most agreements and are similar to liability waivers, but they tend to be more specific in their wording. The indemnification method requires the at-fault counterparty to compensate the responsible counterparty for all losses and damages caused by the early termination.

This method was common when swaps were first developed, but was considered inefficient because it did not actually quantify, or describe how to quantify, those losses and damages from a prematurely terminated swap. Today, the "agreement value method," which is based on the terms and interest rates available for a replacement swap, is the most widely used method for calculating termination payments. Another, less-common alternative is the formula method.

A swap is an agreement made between two counterparties to exchange cash flows (for example, fixed for floating) along with underlying currencies or other securities, such as commodities, terminating at a pre-determined date in the future. A swap contract may be terminated early if either counterparty experiences a credit event or default, such as bankruptcy or failure to pay, or a termination event, such as an illegality, tax event, tax event upon merger, or other contingency. The scope of what counts as an early termination event and how it will be sorted out will be made explicit in the swap's termination clause.

Initially, the indemnity method was used to make whole the counterparty who experienced a loss as the result of the other counterparty terminating the swap agreement early. Under this method, the at-fault (terminating) party must make whole (indemnify) the entire loss experienced by the other party due to the early termination.

However, since it is not clear exactly how much money that counterparty will end up losing, both explicitly and in terms of opportunity costs, the formula method was introduced that would establish a clear methodology for arriving at the indemnity amount, rather than it being an ad hoc tabulation.

Still, the formula method was itself replace by the more commonly used agreement value method, which replaces the non-standardized formula for computing a loss with a simple metric, which is the cost of entering into a replacement swap. The replacement swap entails the new swap agreement that the injured counterparty would have to enter into in order to re-establish the original swap position.

However, since swap prices change over time and as interest rates and other factors fluctuate, the replacement contract may have different terms and market price than the original swap. That difference in cost, to enter the new agreement with another counterparty, is the agreement value, and should indemnify the injured party.