Non proportional reinsurance

Non proportional reinsurance is a type of reinsurance where the reinsurer's liability depends on the size of the loss suffered by the ceding company, specifically when losses exceed a predetermined amount. It is a critical component of risk management for insurance companies, allowing them to protect their financial stability from large, unpredictable losses. Unlike proportional reinsurance, where premiums and losses are shared on a pre-agreed percentage basis, non proportional reinsurance only kicks in once the ceding insurer's losses surpass a specific threshold. This form of reinsurance is designed primarily to provide protection against catastrophic events or unusually large individual claims that could severely impact the insurer's balance sheet.

What Is Non proportional reinsurance?

Non proportional reinsurance, a key strategy within the broader field of risk management, is an arrangement where a reinsurer only pays a claim if the ceding company's loss exceeds a specific predetermined amount, known as the retention limit or attachment point. This means the primary insurer, or ceding company, bears the initial portion of any loss. Once losses from an event or a series of events exceed this threshold, the reinsurer becomes liable up to a specified policy limit. This structure provides the ceding company with protection against severe financial shocks, helping to stabilize its underwriting results and manage exposure to large, unexpected claims.

History and Origin

The concept of reinsurance, in general, has roots tracing back to the medieval period, with early forms emerging in maritime trade. However, the structured approach to non proportional reinsurance, particularly "excess of loss" coverage, developed more prominently in the 20th century. As insured values grew and the potential for large, single losses or widespread catastrophic events increased, insurers recognized the need for protection beyond simple proportional sharing. The National Association of Insurance Commissioners (NAIC) notes that excess-of-loss reinsurance, a form of non-proportional reinsurance, became a more widely used tool to protect insurers from large single claims or catastrophic events as the industry evolved.⁴ The evolution of complex statistical methods and actuarial science also contributed to the ability to price and structure such intricate risk transfer agreements effectively.

Key Takeaways

• Non proportional reinsurance provides coverage to an insurer only when their losses from an event or accumulation of events exceed a predefined retention limit.
• It is primarily used for protection against large, infrequent, or catastrophic losses rather than routine claims.
• Common types include excess of loss and aggregate excess of loss reinsurance.
• This type of reinsurance helps a ceding company stabilize its loss ratio and protect its capital management.
• The reinsurer's liability is capped at a specified maximum amount, known as the policy limit or exhaustion point.

Formula and Calculation

Non proportional reinsurance does not involve a traditional formula for sharing premiums or losses proportionally. Instead, its "calculation" is determined by the specific thresholds agreed upon in the contract. For an excess of loss non proportional reinsurance treaty, the reinsurer's liability is calculated as follows:

[
\text{Reinsurer's Payout} = \min(\text{Total Loss} - \text{Retention Limit}, \text{Policy Limit})
]

Where:

• (\text{Total Loss}) represents the total amount of loss incurred by the ceding company from a single event or accumulation of events.
• (\text{Retention Limit}) (or attachment point) is the maximum amount of loss the ceding company is willing to bear before the non proportional reinsurance coverage activates.
• (\text{Policy Limit}) (or exhaustion point) is the maximum amount the reinsurer will pay for losses exceeding the retention limit. This effectively caps the reinsurer's exposure.

For example, if a policy has a retention limit of $1 million and a policy limit of $5 million, the reinsurer pays for losses between $1 million and $6 million (1M + 5M).

Interpreting Non proportional reinsurance

Interpreting non proportional reinsurance involves understanding the thresholds that trigger the reinsurer's involvement and the maximum coverage provided. A higher retention limit indicates that the ceding company retains more risk, often implying a lower premium for the non proportional reinsurance coverage. Conversely, a lower retention limit means more risk is transferred to the reinsurer, typically at a higher cost. The policy limit is equally crucial, as it defines the maximum risk transfer to the reinsurer, beyond which the ceding company would again bear the full burden of any further losses unless further layers of reinsurance are purchased. These parameters are set based on the ceding company's risk appetite, financial strength, and the nature of the risks it underwrites.

Hypothetical Example

Consider an insurance company, "Coastal Protector Inc.," which primarily insures properties in hurricane-prone regions. To mitigate the impact of a severe hurricane season, Coastal Protector Inc. enters into a non proportional reinsurance treaty for its property portfolio.

The terms of the treaty are:

• Retention Limit (Attachment Point): $10 million
• Policy Limit: $50 million

This means Coastal Protector Inc. will cover the first $10 million in losses from a single hurricane event. If a hurricane causes $40 million in insured losses:

1. Coastal Protector Inc. pays the initial $10 million (its retention).
2. The remaining loss is $40 million - $10 million = $30 million.
3. The non proportional reinsurer then pays this $30 million, as it falls within the $50 million policy limit.

If, however, a catastrophic hurricane causes $80 million in losses:

1. Coastal Protector Inc. pays its $10 million retention.
2. The remaining loss is $80 million - $10 million = $70 million.
3. The reinsurer pays its maximum policy limit of $50 million.
4. Coastal Protector Inc. is then responsible for the remaining $20 million ($70 million - $50 million), which exceeds the reinsurance policy limit. This is often referred to as a "reinstatement premium" or simply the retention beyond the exhaustion point.

This example highlights how non proportional reinsurance protects the ceding company from a significant portion of large, unforeseen accumulated losses.

Practical Applications

Non proportional reinsurance is widely applied in scenarios where insurers face the potential for infrequent but highly severe losses. A primary application is catastrophe bond protection, where it shields insurers from the financial fallout of major natural disasters such as hurricanes, earthquakes, and floods. For instance, following Hurricane Andrew in 1992, which caused unprecedented insured losses, the U.S. property insurance market saw significant changes, including a greater reliance on reinsurance capital from around the world to manage such large-scale events.³ This type of reinsurance also covers large individual risks, such as high-value commercial properties or complex industrial facilities, where a single incident could lead to a massive claim. Furthermore, it is essential for specialty lines of business, like aviation or marine insurance, where the potential for a single, multi-million-dollar loss is always present. Leading reinsurers like Munich Re specialize in providing these types of solutions, covering risks from space rocket launches to cyberattacks.²

Limitations and Criticisms

While non proportional reinsurance offers significant benefits, it also has limitations. One major concern is "basis risk," which occurs when the reinsurance coverage does not perfectly align with the underlying losses experienced by the ceding company. This can happen if the trigger for reinsurance payout (e.g., specific event magnitude or location) does not perfectly match the actual claims incurred, leaving the ceding company with unexpected retained losses. Another criticism relates to the complexity of pricing, especially for tail risks where historical data is scarce, making it challenging for actuarial science to accurately assess probabilities and potential severity. Furthermore, reliance on a few large global reinsurers for such critical protection can pose systemic risks to the broader financial system if these reinsurers face widespread defaults. The International Monetary Fund (IMF) has highlighted the importance of reinsurance in financial stability analyses and discusses the potential for systemic risks within the insurance sector.¹ The cost of non proportional coverage can also be substantial, especially in a hardening market, potentially squeezing the profit margins of primary insurers.

Non proportional reinsurance vs. Proportional Reinsurance

Non proportional reinsurance stands in contrast to proportional reinsurance in how risk, premium, and loss are shared between the ceding company and the reinsurer.

The key difference lies in the trigger for the reinsurer's involvement: non proportional reinsurance focuses on the magnitude of losses, while proportional reinsurance focuses on the share of every policy.

FAQs

What is the main goal of non proportional reinsurance?
The main goal of non proportional reinsurance is to protect the ceding insurance company from the financial impact of large, infrequent, or catastrophic losses that exceed a specific predefined threshold. This helps stabilize the insurer's financial performance and protects its capital.

How does "excess of loss" relate to non proportional reinsurance?
Excess of loss is the most common type of non proportional reinsurance. In an excess of loss arrangement, the reinsurer agrees to pay losses that exceed the ceding company's retention limit, up to a predetermined maximum amount. It directly embodies the principle of non proportional coverage.

Can non proportional reinsurance be applied to multiple events?
Yes, non proportional reinsurance can be structured to cover losses from a single event (per occurrence excess of loss) or aggregate losses from multiple events over a period (aggregate excess of loss). Aggregate excess of loss protects against the accumulation of smaller, but numerous, losses that could collectively exceed a threshold, providing broader risk management for the insurer.

Is non proportional reinsurance expensive?
The cost of non proportional reinsurance depends on several factors, including the retention limit, the policy limit, the type of risk being covered (e.g., catastrophe vs. specific large risk), the historical frequency and severity of losses, and market conditions. Generally, coverage for highly volatile or catastrophic risks can be expensive due to the potential for massive payouts.