A type of reinsurance known as excess of loss reinsurance protects the ceding company, which is the insurance company that passes its insurance portfolio to a reinsurer, from losses exceeding a outlined limit. Meanwhile, the reinsurers, the companies that offer financial defense to insurers, become liable for these losses.
This type of policy is a variant of non-proportional reinsurance. With this type of reinsurance, the insurance firm commits to footing the bill for all losses up until a set maximum limit.
Based on the terminology of the contract, an excess of loss reinsurance policy could either address all loss events within the policy lifespan or losses on aggregate. The use of bands of losses that are incrementally reduced with each claim is a common aspect of these contracts. Both reinsurance and insurance firms use cost calculations, such as the burning-cost ratio, for pricing considerations.
Normally, treaty or facultative reinsurance contracts specify a limit in losses, beyond which the reinsurer will not be liable. Much like a typical insurance plan, such contracts offer coverage up to a fixed limit. While this proves advantageous for the reinsurer, it also tasks the insurance company with reducing the scale of losses.
However, excess of loss reinsurance brings a different element into play. This policy places the onus on the reinsurance company to stand by losses exceeding a pre-decided limit. Hypothetically, in a reinsurance contract containing an excess of loss clause that stipulates a limit of $500,000, the reinsurer becomes answerable for any amount over this figure. In a scenario where total losses tally up to $600,000, for instance, the reinsurer would be on the hook for $100,000.
Alternatively, some excess of loss reinsurance contracts may lay down that the reinsurer is answerable not for the entirety of losses over a certain sum, but for a certain percentage of them. Here, the insurance and reinsurance firms would share the burden of the aggregate losses.
Following the same example, if the contract indicated that the reinsurer should be answerable for half of the losses over $500,000, and if total losses came to $600,000, both the reinsurer and the insurer would split the $100,000 loss, with each shouldering $50,000.
Beyond protecting itself from extreme losses, a ceding insurer extracts greater security for its own equity and solvency from an excess of loss insurance policy. Furthermore, it contributes to financial stability during unusual circumstances or whopping events.
The ability to underwrite policies that insure against a larger spectrum of risks without excessively hiking the costs to maintain their solvency margins -- essentially, the company’s assets at fair values, less its liabilities as well as similar commitments -- is another benefit insurance companies can derive from reinsurance. To sum it up, reinsurance provides insurance companies with substantial liquid resources in case of extraordinary losses.