Excess of Loss Reinsurance
A specific type of reinsurance where the ceding company is compensated for losses that exceed a specified limit
What is Excess of Loss Reinsurance?
Excess of loss reinsurance is a specific type of reinsurance where the ceding company is compensated for losses that exceed a specified limit. The purpose of an excess of loss reinsurance is to assist insurance companies with managing risk. It is a form of non-proportional reinsurance that is centrally focused on loss retention.
Summary
- Excess of loss reinsurance is a specific type of reinsurance where the ceding company is compensated for losses that exceed a specified limit.
- It is based on the principle of loss retention.
- Reinsurance enables insurers to underwrite policies with a larger volume of risks without increasing the costs of meeting solvency margins.
What is Reinsurance?
Reinsurance is a contractual arrangement where an insurer purchases coverage from a reinsurer for potential losses to where it is exposed. Through this manner, insurance companies can manage their downside risk in the case of an event where they have a major payout.
The two major types of reinsurance are proportional and non-proportional reinsurance.
Purpose of Reinsurance
Reinsurance enables insurers to underwrite policies inclusive of a larger overall magnitude of risks without significantly increasing the cost of meeting solvency margins. Solvency margins are the amount that the fair values of assets exceed its liabilities. Therefore, reinsurance companies increase the liquidity of the insurance market.
Proportional Reinsurance vs. Non-Proportional Reinsurance
In proportional reinsurance, the ceding insurer and reinsurer must maintain a post-transfer relationship. Additionally, it is necessary to complete a thorough risk assessment to proportionally allocate premiums, expenses, and losses for all parties involved in the agreement.
Non-proportional reinsurance is based upon the principle of loss retention, which means that the reinsurer fully agrees to reimburse the ceding insurer for all losses exceeding the predetermined limit to the reimbursement limit.
Regardless of whether the reinsurance contract is proportional or non-proportional, all annuity payments are collected in the contract and recorded as financial assets belonging to the ceding insurance company, and the reinsurer is provided security against any financial burden.
Types of Excess of Loss Reinsurance
The three forms of excess of loss reinsurance are:
1. Per Risk XL
In Per Risk XL, the cedant’s insurance policy limits are greater than the amount of reinsurance retention. An example will be if an insurance company insures commercial property risks with policy limits up to $5 million. Then, they purchase per risk reinsurance of $3 million in excess of $2 million.
Assuming a loss of $4 million occurs, $2 million is recovered from the insurance company. As per risk insurance policy contracts, there are usually event limits to prevent the usage of Per Risk XL instead of Catastrophe XL.
2. Catastrophe XL
In Catastrophe XL, the cedant’s retention is generally a multiple of the predetermined underlying policy limit, and the contract also often features a two-risk warranty. Two-risk warranty contract clauses are designed to protect the cedant against catastrophic events that involve more than one policy.
Consider an example where an insurance company issues homeowners’ policies with limits of up to $100,000 and then purchases catastrophe reinsurance equal to $10 million in excess of $2 million. It implies that the insurance company would only recover from reinsurers in the event that there are multiple policy losses in one event, such as a flood or earthquake.
3. Aggregate XL
Aggregate XL provides frequency protection to the reinsured. Consider the case that a company retains $500,000 net in any one vessel, as well as a $2.5 million annual aggregate limit in excess of $2.5 million annual aggregate deductible.
It will result in the cover equating to five total losses in excess of five total losses. Commonly, aggregate covers can also be linked to the cedant’s gross premium income during a 12-month period, with the deductible and limit expressed as a nominal amount or a proportional percentage.
Related Readings
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
