Reinsurance and other forms of risk transfer: types of reinsurance: non-proportional reinsurance: example of excess of loss
Excess of loss is invariably arranged on a treaty basis, and covers losses above the insurer’s retention for all the individual risks within a particular account. For example, a direct insurer writes the same contracts as in GIM8040.
An excess of loss reinsurance treaty of £20,000 in excess of £10,000 is entered into. The amounts payable under the reinsurance treaty would be calculated as follows:
If a claim on policy 1 of £12,000 is paid then the reinsurer will pay the excess £2,000.
A claim of £35,000 on policy 2 would result in the reinsurer paying £20,000 (limit of treaty).
A claim of £60,000 on policy 3 would also result in a reinsurance payment of £20,000 (limit of treaty).
Note that with an excess of loss policy the sum insured is irrelevant when calculating the reinsurance payment, because the reinsurer does not accept a fixed proportion of the total risk. As this form of reinsurance is not proportional premiums are not shared but a price will be agreed to provide £20,000 of cover in excess of £10,000.
Such a policy could also be used to cover an insurer’s retention in relation to risks reinsured through a quota share or surplus treaty. There might be, for example, a five line surplus treaty with an insurer’s retention per risk of £100,000. The insurer may decide to limit its loss per risk to £50,000. To do this it could take out an excess of loss per risk insurance of £50,000 excess of £50,000.
It is usual for the amount the insurer will pay out under such a treaty in total on any one loss event (a storm, for example) to be limited to twice the retention. So even if five buildings were totally destroyed only £100,000 would be paid out. Otherwise the reinsurer would be effectively providing ‘free’ catastrophe excess of loss reinsurance for losses on each building in the range £50,000 to £100,000.