Acquired excess coverage

What Is Acquired Excess Coverage?

Acquired Excess Coverage, often synonymous with excess of loss reinsurance, is a fundamental concept within the broader field of reinsurance and risk management. It describes a type of reinsurance contract where a primary insurer (the "cedent") transfers to a reinsurer the portion of losses that exceeds a predetermined amount, known as the retention or deductible. This financial instrument is crucial for insurers to limit their maximum financial exposure to any single event or a series of events, thereby protecting their solvency and enabling them to underwrite larger or more volatile insurance policies. By utilizing Acquired Excess Coverage, insurers can stabilize their underwriting results and manage their capital allocation more effectively.

History and Origin

The concept of reinsurance, in general, has roots tracing back centuries, evolving from informal arrangements among insurers. The development of specific types of reinsurance, like excess of loss coverage, gained momentum with the increasing scale and complexity of insured risks. Early forms of "excess of loss" arrangements can be traced back to the late 19th and early 20th centuries, particularly as the insurance industry began grappling with large, infrequent claims arising from new liabilities, such as those related to legal indemnities. The earliest English reference to excess of loss cover appeared around 1885, providing a mechanism for companies to avoid being liable for amounts greater than they were prepared to pay for a single event.⁵ This growth was driven by the need to manage potential losses that could severely impact an insurer's financial standing. Catastrophe covers, a significant application of Acquired Excess Coverage, became more common in the United States after World War I, reflecting the industry's continuous adaptation to unforeseen large-scale events.⁴

Key Takeaways

• Acquired Excess Coverage is a form of reinsurance protecting primary insurers from losses exceeding a specified retention level.
• It is crucial for managing large or catastrophic risks that could otherwise destabilize an insurer.
• This type of coverage allows insurers to increase their underwriting capacity and protect their balance sheets.
• Pricing of Acquired Excess Coverage involves complex actuarial science and relies heavily on historical data and catastrophe modeling.
• It plays a vital role in the global financial system by enhancing the overall financial stability of the insurance sector.

Interpreting the Acquired Excess Coverage

Acquired Excess Coverage is interpreted based on its two primary components: the retention (or deductible) and the limit. The retention is the amount of loss the primary insurer agrees to bear before the reinsurance coverage kicks in. The limit, conversely, is the maximum amount the reinsurer will pay for losses exceeding the retention. For example, a contract might specify "$10 million excess of $5 million," meaning the primary insurer pays the first $5 million of a loss, and the reinsurer pays up to an additional $10 million above that, for a total covered loss of $15 million. This structure clearly defines the point at which risk transfer occurs and the extent of the reinsurer's liability. Insurers carefully evaluate their financial capacity and risk appetite to determine the appropriate retention level for their Acquired Excess Coverage, aiming to optimize their capital efficiency while safeguarding against significant events.

Hypothetical Example

Consider "Safe Harbor Insurance," a property insurer. Safe Harbor typically underwrites residential property insurance policies. To protect itself from severe regional weather events, which could lead to numerous large claims, Safe Harbor enters into an Acquired Excess Coverage agreement with "Global Re," a reinsurer.

The terms of their agreement are:

• Retention: Safe Harbor retains the first $10 million in losses from any single catastrophe event.
• Reinsurance Limit: Global Re will cover losses up to $50 million in excess of Safe Harbor's $10 million retention.

Suppose a hurricane causes $45 million in insured losses for Safe Harbor.

1. Safe Harbor pays the first $10 million of the losses as per its retention.
2. The remaining $35 million ($45 million total loss - $10 million retention) exceeds the retention.
3. Global Re, the reinsurer, then pays this $35 million to Safe Harbor, as it falls within the $50 million reinsurance limit.

In this scenario, Acquired Excess Coverage effectively capped Safe Harbor's outflow for this single event at $10 million, protecting its balance sheet from the full $45 million impact and illustrating the critical role of reinsurance agreements in mitigating large-scale financial impact.

Practical Applications

Acquired Excess Coverage finds widespread application across various sectors of the insurance industry, particularly in managing high-severity, low-frequency events. In property and casualty insurance, it is indispensable for covering catastrophe risk exposures such as hurricanes, earthquakes, and wildfires. For example, the U.S. Department of the Treasury highlights the crucial role of the global reinsurance market, including excess of loss coverage, in supporting insurance in the United States, especially after major events like Superstorm Sandy where a significant portion of insured losses were reimbursed through reinsurance.³

Beyond natural disasters, Acquired Excess Coverage is vital for insurers handling large commercial risks, such as aviation, marine, and complex liability coverages, where individual claims can be substantial. It enables primary insurers to offer higher coverage limits to their clients than they could comfortably bear on their own, thereby expanding their underwriting capacity. Additionally, in the context of financial institutions with significant insurance activities, regulatory bodies like the Federal Reserve System oversee their operations, recognizing the interconnectedness of insurance and broader financial stability, which implicitly includes the prudent use of instruments like Acquired Excess Coverage for risk mitigation.²

Limitations and Criticisms

While highly beneficial, Acquired Excess Coverage is not without its limitations and potential criticisms. One significant challenge lies in the complex process of reinsurance pricing. Determining the appropriate premium for Acquired Excess Coverage requires sophisticated actuarial models and extensive data, especially for tail risks that have limited historical precedent. Mispricing can lead to either reinsurers taking on too much risk for insufficient compensation or cedents paying excessive premiums.

Another limitation stems from the cyclical nature of the reinsurance market. During "hard market" phases, when reinsurance capacity is scarce, the cost of Acquired Excess Coverage can increase significantly, and terms may become more restrictive, impacting primary insurers' ability to manage their risks effectively or offer competitive rates. Conversely, a "soft market" with abundant capacity can lead to overly aggressive pricing, which might undermine the reinsurers' long-term profitability and financial strength. Emerging risks, such as climate change and cyber threats, also present challenges, making it difficult to accurately model and price for potential future insurance claims.¹ Furthermore, insurers must manage the counterparty risk associated with their reinsurers; should a reinsurer face insolvency, the primary insurer may not recover the expected indemnification for its losses, leading to unexpected financial strain.

Acquired Excess Coverage vs. Proportional Reinsurance

Acquired Excess Coverage (Excess of Loss Reinsurance) and Proportional Reinsurance represent two distinct approaches to risk transfer in the reinsurance market.

The core difference lies in how risk and premiums are shared. With Acquired Excess Coverage, the reinsurer only becomes involved once a loss surpasses a specific monetary threshold. In contrast, proportional reinsurance involves a fixed percentage sharing of every premium and every loss from the outset. This distinction means that Acquired Excess Coverage is primarily a tool for managing severe, infrequent events, while proportional reinsurance is used more for spreading a portion of the daily underwriting risks and expanding an insurer's overall capacity.

FAQs

What is the primary purpose of Acquired Excess Coverage?

The primary purpose of Acquired Excess Coverage is to protect a primary insurer from severe financial losses that exceed a predefined amount, often arising from a single, large event like a natural disaster or a major liability claim. It caps the insurer's financial outflow per event, safeguarding its balance sheet.

How does Acquired Excess Coverage differ from a standard insurance policy?

A standard insurance policy covers an individual or entity against specific risks, with a deductible paid by the insured. Acquired Excess Coverage, however, is a contract between two insurers: a primary insurer and a reinsurer. The primary insurer is the "insured" in this context, seeking protection for its portfolio of policies against unusually large claims.

Is Acquired Excess Coverage only for catastrophic events?

While Acquired Excess Coverage is widely used for catastrophe risk management, it is also applied to protect against large individual losses from non-catastrophic events, particularly in lines of business where single claims can be substantial, such as professional liability or D&O (Directors and Officers) insurance.

Who benefits from Acquired Excess Coverage?

Both the primary insurer and policyholders ultimately benefit. The primary insurer gains financial stability, allowing it to underwrite more policies and take on larger risks. Policyholders benefit indirectly from the enhanced security and capacity of their insurer, ensuring that claims can be paid even after significant events.