A reinsurance contract can protect an insurer’s balance sheet against abnormal fluctuations in results that may be caused by large individual claims or by larger numbers of smaller claims that occur as a result of a catastrophe or other unforeseen circumstances. These contracts come in many forms. The simplest are those that protect the insurer’s interest in a single policy and are called facultative reinsurance.
Facultative reinsurance is arranged on an individual basis and tends to be time-consuming and expensive to administer. Consequently, insurers will usually try to group large numbers of policies (such as the entire business of the fire or property department) into treaty reinsurance contracts, which provide the insurer with automatic protection for all business that comes within the limits and conditions of the treaty. Both facultative and treaty contracts can be arranged on a proportional or non-proportional basis. The commonest form of non-proportional reinsurance is called excess of loss, the ‘invention’ of which is widely attributed to Cuthbert Heath in the early part of the 20th century.
The main reinsurance types can be summarised in the “family tree” above. In my limited blog space, I shall give a brief explanation of a facultative excess of loss contract and develop the theme in later blogs.
Let’s say you insure your house and its contents for £200,000. Your policy might contain an “excess” or “deductible” of £250. If you volunteer to increase your deductible to £500 you will probably receive a good discount from the premium. Why? Insurers have observed that most losses are small. If we agree to pay the smaller claims ourselves instead of claiming under our policy, we substantially reduce the overall amount of claims the insurer is likely to pay.
For example, statistically losses up to 10% of a property’s value account for 54% of the total of all claims an insurer pays out. Let’s assume an insurer covers a property valued at £100,000,000 and is willing to pay up to the first £10,000,000 of any losses under that policy. The premium to cover the whole value might be £125,000. If we use the above statistic, the total of all claims up to 10% of value account for 54% of the total claims burden.
So an excess of loss contract that only pays the part of each claim that exceeds 10% of the value might only cost 46% of the premium that is charged under the original policy. If the insurer arranged a proportional reinsurance for 90% of the risk, a loss of £10,000,000 under the original policy would result in a £9,000,000 claim upon the reinsurers, so they would naturally expect to receive 90% of the original premium, while under the excess of loss contract, there would be no claim on the reinsurance.
Sharing the Load
So in this example £90,000,000 of excess of loss cover costs 46% of the original premium, while the same amount of proportional cover costs 90%.
It’s not that simple though. Under a proportional contract the insurance company (who is now the reinsured) will be allowed to deduct commission from the reinsurer’s share of the premium to cover its own costs. Under an excess of loss contract, commission is not usually given. And of course, under a proportional contract, the reinsured will recover the agreed percentage of every claim, while under the excess of loss cover, it will only recover amounts in excess of the deductible.
It will come as no surprise that the excess of loss principle can apply not just to a single policy, but to a whole group or “portfolio” of policies, covering risks of difference sizes. “Per-Risk” excess of loss covers will protect the insurer should any claim on any of the risks in his portfolio suffer a large loss that exceeds an agreed “deductible”, while “Catastrophe” covers will protect the insurer in the case of a single event, like an earthquake or a hurricane, that results in the insurer having to pay large numbers of losses that combine to produce a significant “event loss”. We shall explore these in greater detail in subsequent blogs.
This post was originally published March 27, 2013.