What is Interlocking Clause
An interlocking clause is a provision in a reinsurance treaty used to determine how to allocate a loss between two or more reinsurance treaties. Interlocking clauses are useful when a loss comes from a single occurrence.
BREAKING DOWN Interlocking Clause
The manner in which insurance companies treat time can be complicated, with differences in accident years, reporting years, and underwriting years impacting the treatment of losses. In some cases, an insurer may purchase multiple reinsurance treaties to cover the same risk over different time periods. Since there are several reinsurance treaties, the insurer must apportion loss among them. Spreading loss among contracts is possible due to the inclusion of an interlocking clause in the reinsurance treaties. Interlocking clauses will most likely occur when the insurer purchases reinsurance on an underwriting year basis.
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. Without the interlocking clause, the reinsured is responsible for the entire retention of each reinsurance treaty or underwriting year, which 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. Apportioning the loss across numerous time periods without also distributing the loss retention and coverage means that a loss from a single occurrence is less likely to exceed the retention level. Additionally, the reinsurer is less likely to be liable for any loss, and the reinsured is more likely to be solely responsible for covering the loss.
Interlocking Clause Example
For example, an insurance company purchases a reinsurance treaty with an interlocking clause to protect it from excess losses. The reinsurance treaty covers two different years, 2016 and 2017. In 2016, the reinsurer has coverage of $400,000 over a $300,000 retention guideline. In 2017 the reinsurer has coverage of $500,000 over a $200,000 retention threshold. The terms of the agreement apportion and allocate the coverage and the retention proportionally. In this case, the year 2016 will take 25% allocation, and the year 2017 will take 75% allocation. The reinsured experiences a loss of $500,000 in 2017. Because of proportional allocation of losses, coverage, and retention, the reinsurer is liable for $275,000, or 25% or the allocated coverage. Had the reinsurance treaty only apportioned the loss across one period, the reinsurer would have had a liability of $175,000.
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, meaning the loss will not be allocated across multiple reinsurance treaties.