In principle, a ratchet option is an option (or a warrant, index-linked note) that subjects its minimum payoff to an upward rest when the underlying price/ rate hits or trades through pre-defined threshold levels (steps) or reaches a specific level on preset reset dates. Once a ratchet mechanism is set on, a minimum level of the option’s payout can be guaranteed, even if the underlying price/ rate subsequently declines.

In insurance, a ratchet option can allow the policyholder to improve the guaranteed benefit amount to the higher of two values: 1) the account value and 2) the current guarantee amount on the ratchet date, while the contract term remains unadjusted. The option’s gains are locked in on reset dates for the option’s holder. Such an option can be linked to an equity index and resets periodically (e.g., monthly) at the money (ATM). Maturities may cover periods shorter than insurable annuities (e.g., 1 -2 years), but these options can be hedged from the market to cover longer maturities with lower costs.

A ratchet option is also known as a ladder option or a cliquet option.