What Is an Interlocking Clause?
The term "interlocking clause" refers to a provision found in a reinsurance treaty. The provision is used to determine how to allocate a loss between two or more reinsurance treaties. The interlocking clause allows the reinsured to spread the risk across at least two agreement periods. An interlocking clause is useful when a loss comes from a single occurrence, such as a natural disaster or another catastrophic event.
- An interlocking clause is a provision found in a reinsurance treaty that is used to determine how to allocate a loss between two or more reinsurance treaties.
- The clause allows the reinsured to spread the risk across at least two agreement periods.
- Interlocking clauses come in most handy when a loss comes from a single occurrence, such as a natural disaster.
- If an insurer has purchased multiple reinsurance treaties to spread out risk, then it must spread the loss between them as well.
- If no interlocking clause exists, the reinsured assumes the responsibility for the entire retention of each treaty or underwriting year and could result in the reinsured not receiving a loss payout.
How Interlocking Clauses Work
The way insurance companies treat time is often complicated. Differences in accident years, reporting years, and underwriting years are just some of the factors that impact the treatment of losses.
In some cases, an insurer may purchase multiple reinsurance treaties to cover the same risk over different time periods. When there are several reinsurance treaties, the insurer must spread loss between them. This is possible with the inclusion of an interlocking clause.
Reinsurance occurs when an insurer transfers part of its risk portfolio to other entities through an agreement to reduce paying a large obligation that stems from an insurance claim.
Interlocking clauses are used to apportion or allocate a liability associated with a single occurrence. It is useful when the reinsured has two additional parallel reinsurance treaties, or when a separate reinsurance treaty has two underwriting years that may be interlinked.
Without the interlocking clause, the reinsured is responsible for the entire retention of each treaty or underwriting year. This could result in the reinsured not receiving a loss payout.
The critical aspect of an interlocking clause is how it allocates and apportions the loss across multiple years, and how the assigned proportions relate to loss retention and coverage. Allocating the loss across numerous time periods without distributing the loss retention and coverage means that a loss from a single occurrence is less likely to exceed the retention limit.
This is the total risk an insurer agrees to retain. The reinsurer is also less likely to be liable for any loss, and the reinsured is more likely to be solely responsible for covering the loss.
Reinsurance treaties that do not have an interlocking clause treat all losses from a single occurrence as if there was a single date of loss. This means the loss will not be allocated across multiple reinsurance treaties.
Example of an Interlocking Clause
Here's a hypothetical situation to demonstrate how an interlocking clause works. Let's say an insurance company purchases a reinsurance treaty with an interlocking clause to protect it from excess losses.
The reinsurance treaty covers two different years. For the first year, the reinsurer has coverage of $400,000 over a $300,000 retention guideline and for the second year, the reinsurer has coverage of $500,000 over a $200,000 retention threshold.
The largest reinsurance company in the world is Munich Re, with gross life and non-life reinsurance premiums written of $45.8 billion in 2020.
The terms of the agreement apportion and allocate the coverage and the retention proportionally. In this case, the first year takes a 25% allocation while the second year takes a 75% allocation.
Let's assume the reinsured experienced a loss of $500,000 in the second year. Because of the proportional allocation of losses, coverage, and retention, the reinsurer is liable for $275,000 or 25% of the allocated coverage. Had the reinsurance treaty only apportioned the loss across one period, the reinsurer would have had a liability of $175,000.
What Is Reinsurance?
Reinsurance is a way for an insurance company to spread out its risk by purchasing multiple insurance policies from other insurers, which limits the total loss payout that it would need to pay in the event of an accident or catastrophe. In its simplest form, reinsurance is insurance for insurance companies.
What Is Treaty Reinsurance?
When an insurance company purchases insurance from another insurance company, that is known as treaty reinsurance. The reinsurance company assumes the risks that are specified in the contract in exchange for an insurance premium.
What Happens if There Is No Interlocking Clause?
If there is no interlocking clause then the reinsurance company assumes all of the responsibility for the retention treaty or underwriting year, which could possibly result in the reinsurance company not receiving any loss payout.
What Is Facultative Reinsurance?
When an insurance company purchases insurance to cover a single risk or block of risks that are part of its business, that is known as facultative reinsurance. Facultative reinsurance is a deal that is considered a one-time transaction whereas treaty reinsurance is more of a long-term agreement that would cover multiple risks over an extended period of time.
The Bottom Line
Interlocking clauses are provisions found in reinsurance treaties that determine how losses are allocated between two or more reinsurance treaties. An interlocking clause gives a reinsurer the permission to spread losses out over two or more agreement periods, which is an easier financial burden to bear.