Trumpflation and the need for the Index Clause:
After the 2016 election, many economist are predicting the new administration’s policies will add to the existing threat of rapid inflation. The previous two administrations policies’ and Quantitative easing (QE) are partially to blame – plus the conservative budget hawks’ forecasts of the next 4 years policies, specifically reducing taxes & increasing government infrastructure spending, will have an impact on the amount of money supply in the economy.
This will have interesting impacts throughout all areas of the economy, but as it relates to reinsurance – including jury awards, medical inflation, legal and expense trend, etc. In regards to how reinsurance companies are going to respond, some are predicting that Trumpflation and the need for the Index clause will be highly correlated.
The index clause
A contractual provision that was developed as a means of combating the difficult reinsurance problems raised by inflation is the index clause. This contract term calls for the primary company’s retention to be determined at the time the loss is paid by multiplying the retention at the time the loss occurred by the percentage growth in an agreed index.
This leads to a more equitable sharing of the inflation between the primary company and the reinsurer.
This clause was developed in Europe to benefit reinsurance companies so they were not so significantly exposed to increases in inflation.
If these economist are correct about Trumpflation, those reinsurers that continue to price casualty business are taking model risk with the estimate of future inflation. Should the inflation trends materially change or differ from estimates at the time of pricing, this will have a direct impact on reinsurer earnings.
Investors should be aware of the impact to those reinsurers offering long tail casualty products.
Prediction, that we will see this Index clause reintroduced in future reinsurance markets or results will suffer….not sure which will occur first. As margins are compressing in the sector, there doesn’t appear to be enough margin to account for inflation/model risk.