Excess of loss reinsurance

What Is Excess of Loss Reinsurance?

Excess of loss reinsurance is a type of non-proportional reinsurance where a reinsurer indemnifies a ceding company for losses that exceed a predetermined amount, known as the retention or priority. This financial arrangement falls under the broader category of Insurance and Risk Management. Unlike proportional reinsurance, the reinsurer does not share a fixed percentage of every policy's premiums and losses. Instead, excess of loss reinsurance is designed to protect insurers from large, catastrophic losses that could otherwise significantly impact their financial stability or deplete their capital. The primary insurer bears all losses up to the specified retention level, and the reinsurer covers the portion of the loss exceeding that amount, up to an agreed-upon limit²⁶, ²⁷.

History and Origin

The concept of risk sharing dates back to ancient times, with early examples found in Chinese merchants spreading cargo across multiple ships and Babylonian maritime loans²⁵. Formal insurance contracts and, subsequently, reinsurance practices, began to develop in the 14th century, primarily in the context of marine trade in Italy²³, ²⁴. The need for more structured reinsurance mechanisms grew with industrialization and urbanization in the 19th century, which led to greater concentrations of risk, particularly in fire insurance²².

The world's first dedicated and independent reinsurer, Cologne Re, was established in 1842 following the Great Fire of Hamburg²¹. This period saw the emergence of specialized reinsurance companies to help primary insurers manage increasingly large and complex risks²⁰. Excess of loss reinsurance, as a distinct form, began to take shape later in the 19th century. Notably, Swiss Re, a prominent global reinsurer, underwrote its first excess of loss contract in 1890, marking a significant evolution in how insurers transferred and managed their most severe risks¹⁹.

Key Takeaways

• Excess of loss reinsurance protects primary insurers from large, infrequent, but severe losses that exceed a specific retention level.
• It enhances the solvency and underwriting capacity of insurers, allowing them to take on more significant risks than they could otherwise retain.
• This type of reinsurance is crucial for managing catastrophic exposures, such as those arising from natural disasters or large liability claims.
• There are different forms of excess of loss reinsurance, including "per risk," "per occurrence," and "aggregate" covers, each tailored to specific risk profiles.
• It is a non-proportional agreement, meaning the reinsurer's payment is triggered only when losses surpass a predetermined threshold, not as a fixed percentage of all losses.

Formula and Calculation

Excess of loss reinsurance does not rely on a single, universally applied formula in the same way a financial ratio might. Instead, its "calculation" involves defining key parameters within the reinsurance contract that dictate how losses are shared. The core elements are the retention (or priority) and the reinsurance layer.

Consider the following:

• Retention Point (R): This is the amount of loss the insurer agrees to bear before the excess of loss reinsurance coverage kicks in.
• Reinsurance Layer (L): This is the maximum amount of loss the reinsurer will cover above the retention point.

The reinsurer's payment for a given loss event is calculated as:

Where:

• (\text{Loss Event}) = The total insured loss incurred by the ceding company from a single event or a collection of events (depending on the type of excess of loss coverage).
• (\text{max}(0, \ldots)) ensures the payment is not negative.
• (\text{min}(\ldots, L)) ensures the payment does not exceed the reinsurance layer limit.

For example, if an insurer has an excess of loss treaty with a retention of $1,000,000 and a layer of $4,000,000 excess of $1,000,000, the reinsurer would pay for losses between $1,000,000 and $5,000,000. If a loss of $3,000,000 occurs, the insurer pays the first $1,000,000, and the reinsurer pays the remaining $2,000,000. If the loss is $6,000,000, the insurer pays $1,000,000, the reinsurer pays their full layer of $4,000,000, and the insurer retains the additional $1,000,000 beyond the reinsurance layer.

This structure allows the ceding company to cap its maximum exposure to any single large loss or accumulation of losses, protecting its balance sheet and allowing for more predictable financial outcomes.

Interpreting Excess of Loss Reinsurance

Interpreting excess of loss reinsurance involves understanding its role in an insurer's overall risk management strategy. This form of reinsurance is primarily used to protect against high-severity, low-frequency events, meaning events that are rare but could cause immense financial damage. By setting a specific retention, the insurer consciously decides the maximum amount of loss it is willing to bear from a single event or a collection of events.

The selection of the retention level is critical; a higher retention means the insurer retains more risk but pays a lower premium to the reinsurer. Conversely, a lower retention reduces the insurer's exposure but increases the reinsurance cost. This decision is influenced by the insurer's financial strength, its risk appetite, and the nature of the portfolio of risks it has underwritten. For example, an insurer operating in a hurricane-prone region would likely utilize excess of loss reinsurance to protect against large natural catastrophe losses, interpreting it as a critical buffer against insolvency in extreme scenarios.

Hypothetical Example

Consider "Coastal Casualty Insurance," a primary insurer specializing in property insurance along a hurricane-prone coast. Coastal Casualty has a strong balance sheet but wants to protect itself from catastrophic hurricane losses that could exceed its financial capacity.

They enter into an excess of loss reinsurance treaty with "Global Re," a large reinsurer, with the following terms:

• Retention: Coastal Casualty will retain the first $5 million of any single hurricane event loss.
• Reinsurance Layer: Global Re will cover losses from $5 million up to $50 million.

One year, a major hurricane strikes, causing $30 million in insured losses to Coastal Casualty's policyholders.

Here's how the excess of loss reinsurance works:

1. Coastal Casualty's Initial Responsibility: Coastal Casualty pays the first $5 million of the $30 million loss, as this is their agreed-upon retention.
2. Global Re's Involvement: The remaining $25 million ($30 million total loss - $5 million retention) falls within Global Re's layer of coverage ($5 million to $50 million).
3. Payment: Global Re pays Coastal Casualty $25 million.

In this scenario, Coastal Casualty effectively caps its exposure at $5 million for this major event, preserving its financial strength and enabling it to continue honoring other claims and underwriting new policies. Without this excess of loss protection, Coastal Casualty would have had to bear the full $30 million loss, which could have severely impacted its operations and solvency.

Practical Applications

Excess of loss reinsurance is a cornerstone of modern risk management for insurance companies, primarily used to mitigate the impact of severe and unpredictable events.

Key practical applications include:

• Catastrophe Risk Management: This is perhaps the most prominent use. Insurers utilize per occurrence excess of loss reinsurance to protect against large losses arising from a single catastrophic event, such as earthquakes, hurricanes, or floods¹⁷, ¹⁸. For instance, a natural disaster, like Hurricane Ian in 2022, which contributed significantly to global insured losses, demonstrates the critical role of reinsurance in absorbing such large-scale financial impacts for primary insurers¹⁶.
• Managing Large Individual Risks: For very large individual policies, such as those covering major infrastructure projects or large commercial properties, an insurer might purchase per risk excess of loss reinsurance to cap its exposure on that single policy.
• Expanding Underwriting Capacity: By transferring portions of significant risks, insurers can write more policies and take on larger exposures than their own capital base would typically allow, thereby increasing their overall underwriting capacity and enabling market growth¹⁴, ¹⁵.
• Financial Stability and Regulatory Compliance: Reinsurance contributes to the financial resilience of insurers and helps them meet regulatory capital and reserve requirements¹², ¹³. The ability to transfer tail-end risks through excess of loss policies is vital for maintaining a strong financial position, particularly in the face of unexpected large losses¹¹.
• Aggregate Loss Protection: Aggregate excess of loss reinsurance covers the accumulation of smaller, but frequent, losses over a defined period that, in total, exceed a certain threshold. This is valuable for managing risks that might not be individually catastrophic but can cause significant financial strain when combined¹⁰.
• Alternative Risk Transfer: While traditional reinsurance forms the backbone, instruments like catastrophe bonds and insurance-linked securities (ILS) serve as alternative capital sources that can also provide excess of loss type coverage, transferring specific event risks directly to capital markets investors⁸, ⁹.

These applications highlight how excess of loss reinsurance allows primary insurers to stabilize earnings, manage volatility, and ultimately ensure they can fulfill their obligations to policyholders even after severe loss events.

Limitations and Criticisms

While excess of loss reinsurance is a vital tool for insurers, it is not without its limitations and criticisms:

• Cost and Availability: In periods of "hard markets," where capacity shrinks and demand for coverage increases, the premium for excess of loss coverage can become very expensive, or certain layers of coverage may become difficult to obtain⁶, ⁷. Reinsurers may also demand higher attachment points and stricter terms, forcing primary insurers to retain more risk⁵.
• Basis Risk and Modeling Challenges: The effectiveness of excess of loss reinsurance heavily relies on accurate risk assessment and catastrophe modeling. If the models used to price the risk or define the trigger for the excess of loss coverage do not align perfectly with actual losses, the ceding company might experience "basis risk," where the reinsurance does not fully cover the losses anticipated. Climate change and new types of perils further complicate accurate modeling³, ⁴.
• Counterparty Risk: Although less common with highly rated global reinsurers, there is always an inherent counterparty risk. If the reinsurer becomes insolvent, the ceding company may not recover the amounts due under the treaty².
• Moral Hazard: While reinsurance is designed to enable insurers to take on appropriate risks, some critics suggest a potential for moral hazard. If a primary insurer relies too heavily on reinsurance, it might become less diligent in its own underwriting or claims management practices, knowing that severe losses will be borne by the reinsurer.
• Profit Volatility: Even with excess of loss coverage, significant volatility can occur for the primary insurer if losses consistently fall just below the retention level, or if accumulated smaller losses (not covered by typical per-occurrence excess of loss) still impact profitability.
• Market Dynamics: The reinsurance market's shift towards alternative capital and insurance-linked securities can put pressure on traditional reinsurance models. Some analysts have raised concerns that the stand-alone reinsurance model, especially for certain players, may become unsustainable if market conditions do not support adequate returns¹. This ongoing evolution means reinsurers, and by extension, their excess of loss offerings, must constantly adapt.

Excess of Loss Reinsurance vs. Proportional Reinsurance

Excess of loss reinsurance and proportional reinsurance are two fundamental approaches to risk transfer in the reinsurance market, differing primarily in how risk and premium are shared between the primary insurer and the reinsurer.

The key distinction lies in the proportionality of the risk and premium sharing. With proportional reinsurance, every dollar of premium and loss is shared according to a pre-agreed percentage. With excess of loss, the reinsurer only becomes involved once the primary insurer's losses cross a specific monetary threshold, providing a safety net against severe financial shocks without sharing in the day-to-day smaller claims.

FAQs

Q1: What types of losses does excess of loss reinsurance primarily cover?

Excess of loss reinsurance primarily covers large, unpredictable losses that exceed a specific amount. This often includes severe individual losses, or aggregate losses from catastrophic events like natural disasters (e.g., hurricanes, earthquakes, floods), major industrial accidents, or large liability claims. It's designed to protect against the "tail" risks that could severely impact an insurer's balance sheet.

Q2: How does an "attachment point" relate to excess of loss reinsurance?

The attachment point (often synonymous with retention or priority) in an excess of loss treaty is the specific monetary threshold at which the reinsurer's obligation to pay begins. The primary insurer is responsible for all losses up to this point. For example, if the attachment point is $10 million, the primary insurer pays the first $10 million of a loss, and the reinsurer covers the amount exceeding that.

Q3: What is the benefit of excess of loss reinsurance for a primary insurer?

The main benefit for a primary insurer is the protection against severe financial shocks. It allows the insurer to limit its maximum potential loss from a single event or a series of events, thereby safeguarding its capital and maintaining its solvency. This stability enables the insurer to take on larger or more volatile risks, expand its underwriting capacity, and offer more comprehensive coverage to its policyholders.