What is Index Linking?
What is Index Linking? In the simplest terms, index linking is a feature that some insurance policies include to ensure that the pay-out you receive from your claim keeps pace with inflation.
It's all about maintaining the 'real' value of your insurance cover over time.
Why is this important? Well, as time goes by, the cost of goods and services tends to increase – a process known as inflation. This means that the same amount of money will buy less as time progresses. If your insurance cover isn't keeping up with these changes, you could find yourself in a situation where it's not enough to cover your losses, resulting in underinsurance.
That's where index linking comes in. Index linking adjusts the sum insured annually in line with an appropriate index. For example, if you have a home insurance policy, the index used might be a construction cost index or a house price index. The principle is that the value of your cover should keep pace with the costs you might incur if you had to make a claim.
An example of Index Linking
To help you understand here is an example of Index Linking-
Imagine you take out a home insurance policy in 2023, and the sum insured (the maximum amount your insurer will pay out for a claim) is £200,000. Unfortunately, you have a major incident in 2028 that results in you having to rebuild your house.
If there was no index linking, you'd still have that £200,000 to put towards the rebuild. However, due to inflation, the actual cost of rebuilding your house has risen to £230,000 over those five years. That leaves you with a £30,000 shortfall that you'd have to find from your own pocket.
However, if your policy had been index-linked, the sum insured would have increased each year in line with the index (let's assume it accurately reflected the cost of rebuilding). This means by the time you needed to claim in 2028, the sum insured might also have increased to the required £230,000, covering the full cost of the rebuild.
Index Linking - things to remember
Like anything in the world of insurance, there are a few things to remember with Index Linking.
Firstly, it's worth mentioning that index linking can result in your premiums increasing over time, as the value of your cover increases. However, it's a small price to pay for the peace of mind that comes from knowing your cover is keeping up with inflation.
Secondly, index linking relies on the accuracy of the index used. These indices are just estimates, and they might not perfectly reflect the changes in costs that you personally would face if you had to make a claim.
Lastly, while index linking can help your cover keep pace with inflation, it doesn't necessarily account for changes in the value of individual items. If you have specific high-value items on your policy (like jewellery or works of art), it's always a good idea to have these revalued regularly to ensure they are adequately covered.
Index linking is a powerful tool in the insurance industry that helps to ensure your policy continues to provide adequate cover over time. While it does have its limitations and might increase your premiums slightly, the benefits often far outweigh these considerations. As with all elements of your insurance policy, it's crucial to understand how it works and ensure it's the right choice for your specific needs.