The dynamics of excess of loss reinsurance

Preface

Robert Kiln in his book, Reinsurance in Practice has rightly observed to describe the reinsurance, “The two functions of reinsurance—the laying off or on passing on of liability on insurance and the protection of insurance account—should be remembered. They overlap at times but are nevertheless the two fundamental and distinct functions of all reinsurers”.

The nature of reinsurance contracts primarily encompasses the ‘assumption of risk theory’ which states that in return of for a share of the premium, the reinsurer assumes a corresponding share of the risk from the direct insurers. Assumption of risk by the reinsurer may be ‘contributory’ through specific cession on individual risk or on a portfolio of risks, whereas under ‘non-contributory’ type, the reinsurer assumes the aggregate exposure to the reassured’s portfolio up to a limit that exceeds a pre-determined limit. To that extent, the non-contributory type of risk transfer mechanism which is more popularly known as ‘Excess of loss reinsurance’ is recognised as a contract of reinsurance rather than a contract for reinsurance, a contract which is relevant to open cover and surplus treaty type of reinsurance.

By default, the insurance industry always faces number of life threatening risk financing challenges. The insured values at risk continue to grow faster than the capital currently underpinning the insurance industry. The increased emphasis on role and value of capital has highlighted the need and importance for primary insurers to focus on the risk financing tools to provide them a form of contingent capital. In balance sheet terms, reinsurance facility fulfils three primary functions: liquidity, temporary capital and risk transfer. 

Evolution of excess of loss reinsurance

In the history of the business, up to mid-19^th century, reinsurance was effected between one direct insurer and another, at first on facultative basis, subsequently by treaty and for a good many years by both methods concurrently. Though methods of reinsurance continued for many years on these lines, the march of events brought certain inevitable developments which had a marked effect on the mechanism of risk transfer. Sharing of risk began changing forms due to increased nature and complexity of risk requiring reduction of the magnitude of exposure, initially on micro basis, risk by risk, later on macro form on a portfolio basis. While facultative reinsurance reduces peak exposure, surplus and quota share treaty reduce individual exposure. Yet there is another side to the picture of risk accumulation. Increased loss ratio arising from attrition of losses together with increased magnitude of loss caused by several risks exposed to a single catastrophic event arising from conflagration or natural disaster, gave rise to the emergence of excess of loss reinsurance. This is formed on non-proportional basis to provide protection of balance sheet of the ceding company. Therefore, while the proportional treaty which is a contributory type is more of a ‘risk reinsurance’, the excess of loss insurance which is non-contributory types is a form of ‘loss reinsurance’. The non-proportional covers are thus based, not on the sum assured, but on the claims cost or loss portfolio of the reassured. This cost could be measured in various ways and the covers are thus traditionally categorised as follows:

• Individual risk exposure on first loss basis (Facultative excess of loss)

• Cost of single claim on any one risk on a given portfolio (Risk excess)

• Cost of a claim or series of claims caused by a single event (Cat XL)

• Cost of claim caused by a ‘second event’ (Second event XL cover)

• Unknown accumulation of the entire portfolio comprising all classes (Whole account XL)

• Aggregate cost of all claims in any one year (Stop loss XL)

• Cost of claims exceeding available indemnity (Benefit XL cover)

• Reinstatement premium protection (RPP XL cover)

• Accumulation between two or more classes on one event (Umbrella cover or clash cover) 

The structure of reinsurance has to be regarded from two points of view—ceding company and reinsurer. While instituting the risk transfer mechanism, a primary insurer’s major concern is to reduce the overall exposure of the book of business being written during a particular period. Within that mechanism, the magnitude of overall risk exposure is progressively reduced by first reducing a peak exposure through facultative method followed by further reduction of individual exposures through a contributory treaty. The remaining accumulations are then protected by an excess of loss contract against any unforeseen disaster. While discharging these functions of reinsurance, both parties, the reinsurer and ceding company, play a part in the making of reinsurance transaction although each of the players approaches it from the opposite point of view. The ceding companies or primary insurers concentrate on ‘law of large numbers’ while assuming the risk; the reinsurers on the other hand, are guided by the operation of ‘law of average’.

Reinsurance perspective—Cedant’s viewpoint

A ceding company traditionally seeks protection of losses that may arise in different forms in terms of frequency or magnitude depending on its portfolio that is exposed to various perils. The primary objective of seeking such protection stems from the following factors:

• Economy & convenience

• Premium conservation

• Protection against unknown accumulation for improper monitoring of aggregates

• Difficulties of defining ‘any one risk’

• Difficulties in classification of risk being protected under proportional cover

• Protection against catastrophic event causing series of losses in one single class or many classes

• Protection against inter-departmental accumulation

• Unlimited liability caused by legislative provisions such as motor third party, WC (workers compensation) liability, etc. 

Types of excess of loss cover usually taken by primary insurers may be diagrammatically expressed as follows:

The individual risk excess cover may be taken by the ceding company based on the law of probabilities. It is described as ‘exposure to risk’ or sometimes by estimating the ‘probable maximum loss’, generally reckoned as a percentage of the total sum insured. Accumulation of losses arising from a loss producing event often takes place. Risks are always not independent of each other as assumed, and in any case, an event or occurrence may affect more than one risk. Losses may also accumulate from policies written in different department within the company itself. One single event likes fire, natural disaster, collision or accident may give rise to a single loss or multiple losses to property, casualty, and liability together. Following scenario may be taken as a model to describe the dynamics of excess of loss insurance cover for a ceding company:

Scenario—A

Other things remaining same, the cedant may proceed to structure the XL program naming it as ‘non marine excess of loss cover’ under the following categories keeping in mind the issue of cash flow with a full protection of the portfolio:

• Peak risk protection through facultative excess cover up to a limit of $3 million in 2 or 3 layers with an underlying limit of $250,000
• PML error cover for the 3 peak risks combined on ‘any one loss’ (AOL) basis as a ‘sleep easy cover’ with a limit of $7 million assuming there is no conflagration
• Risk excess cover for each & every risk (E&ER) in 4 layers with a total limit of $10 million including the underlying of $250,000 with an inuring benefit to the Cat XL Program (excluding the three peak risks)
• Catastrophe XL cover to a suitable limit assuming 10% of 900 risks will be affected on any one event on any one zone producing a likelihood of a loss of $22.5 million (90 x $250,000 of each risk value)

A second event cover, stop loss cover or an umbrella cover may also be considered to take care of residual exposures exceeding protection available under the overall proportional and non-proportional program resulting from extra-ordinary severe catastrophes, PML miscalculations or another serious catastrophe taking place within the same period affecting the entire portfolio.

Reinsurer’s perspective

Within the above scenario, the reinsurer would examine the stability of results of the portfolio over last few years including the underwriting philosophy of the cedant just to ensure that the trend of underwriting does not deviate from the natural path. To make sure that the portfolio protected is not unduly influenced by the event beyond control, the reinsurer may like to emphasise on the following points while granting the cover: 

• The original underwriting of the ceding company should not be on PML basis unless agreed by the reinsurer before assumption of the risk.

• The Cat XL program is subject to 2-risks warranty that has got an inuring benefit of the underlying risk XL cover.

• There is no assumed account reflected in the portfolio protected.

• The reinsurer may also carefully examine the return cycle of the catastrophic event peculiar to the territory protected to calculate their minimum ‘rate on line’ (ROL). 

To establish prudence in assuming the risk or in settling the losses by the ceding company, many reinsurers may insist that the cedant becomes a co-reinsurer within the catastrophe program. The share that the ceding company is expected to take may vary between 5% and 10%.

To further protect its own net account that may affect its retrocession facility, the captioned reinsurer may consider prohibiting the cedant from purchasing of additional layers in respect of the portfolio being protected without prior consent of the reinsurer.

If the portfolio protected falls in a territory or a region that is traditionally influenced by a repeat catastrophe, the reinsurer may perhaps consider granting limited reinstatement or increasing the rate on paid reinstatement. It is further important for the reinsurer to consider paid reinstatement with appropriate loading such as first reinstatement with 150% additional premium, pro-rata to amount and annual in time. However, in an ideal situation, the ceding company would always insist on unlimited free reinstatement which is tantamount to unlimited protection, but in the real world, unlimited over is rarely feasible oris prohibitively expensive.

The situation of the above reinsurer is to be seen from the nature of the ceding company which is primarily a direct insurer. If however, the ceding company‘s portfolio comprises reinsurance assumed account accepting treaty and facultative business in various forms, the dynamics would be dramatically different for the reinsurer as they will become the retrocessionaire. The real exposure to an excess retrosurer of a third party reinsurance account is to be judged best not on the premium income but on the exposures in the portfolio which exceed the excess point or deductible of the retrosurance account. These exposures will be affected by the size of the line written by the retrocedent on each contract, i.e. by the percentage of the original contract accepted by him.

In carrying out the exercise of granting reinsurance cover, the reinsurer has to consider the methods to be adopted in the investment of its funds. Capital apart, the reinsurer should also emphasise on accumulating reserve funds, partly to provide for unexpired risks and outstanding losses, and partly as surplus funds for contingencies.

The outcome

The foregoing analysis of the respective observations on the part of the ceding company and the reinsurer, presupposes a state of affairs in which each party sets out to fill its own particular needs—the cedant to obtain satisfactory reinsurance protections and reinsurer to obtain profitable business over a reasonable period of time on satisfactory terms, unaffected by any outside considerations following the rules of business. There are always some situations that may materially affect any decision making process on the part of both the ceding company as well as the reinsurers. These reflections on the subject of arranging reinsurance facility to a desired extent clearly show that there will be some areas of essential differences between the ceding company and the reinsurer that needs a proper appraisal and observing how they are reconciled so as to produce harmony in the closed transaction.

(The author is a PhD, ANZIIF (Fellow) CIP. He is a former underwriter of GIO Re Sydney and currently is the Director, International Business of an international firm, Kaden Boriss Lawyers, Australia. Kaden Boriss also has offices in Canberra, Singapore, New Delhi and Bangkok.)