Definition
Excess of Loss Reinsurance is a type of reinsurance in which the reinsurer is responsible for covering losses exceeding the insurer’s predetermined limit. This limit is set on a per claim or per insurance policy basis. Its primary function is to protect the insurer from catastrophic losses, thereby providing financial stability.
Phonetic
Eks-es ov Los Ree-in-shoor-ens
Key Takeaways
<ol> <li><strong>Risk Transfer:</strong> Excess of Loss Reinsurance is a type of reinsurance in which the reinsurer is responsible for covering losses exceeding a specific amount or excess point predefined by the primary insurer. This is an effective risk management tool for insurance companies, providing a method of risk transfer and helping manage large losses.</li> <li><strong>Profitability:</strong> This type of reinsurance can increase the profitability of the primary insurer by reducing their potential maximum loss. It allows them to underwrite policies that cover a higher risk than they would otherwise be able to handle.</li> <li><strong>Limitations:</strong> While Excess of Loss Reinsurance mitigates the potential for large losses, it may also limit the insurer’s potential for profit. Since the reinsurer will cover losses past a certain threshold, any premiums gathered over this amount will usually be retained by the reinsurer, thereby limiting the overall profit that can be achieved by the primary insurer.</li></ol>
Importance
Excess of Loss Reinsurance is an essential business and financial term because it represents a risk management strategy where a company purchases insurance to protect itself from losses that exceed a specified limit. Essentially, the reinsurer covers losses that surpass the primary insurer’s predetermined retention limit. This practice is significant because it allows insurance companies to limit their exposure to significant claims or multiple smaller claims. This risk transfer helps insurance companies maintain financial stability, ensures their solvency and allows them to take on further risks. So, it plays a central role in the financial security and growth of an insurance company, and ultimately, in the entire insurance industry.
Explanation
Excess of Loss Reinsurance, as a protective tool in the financial management field, is essentially designed to cover a predefined amount of losses that exceed a certain limit set by the party purchasing the reinsurance. The purpose of this instrument is mainly to shield insurance companies from significant financial losses that go beyond their risk-bearing capacity. Often, catastrophic events or huge liabilities bring about these types of losses. Insurers, therefore, tap into this type of reinsurance to manage and spread the risk, maintaining financial stability even in the face of large claim events.When insurance firms underwrite policies, they take on the risk of having to pay out massive claim amounts if an insured event, such as a large-scale disaster or a series of substantial losses, unfolds. If these claims surpass their set threshold, the insurers’ operational viability may be in jeopardy. This is where the Excess of Loss Reinsurance comes in handy, as it kicks in to cover the portion of the claims that excesses the predetermined retention limit. The reinsurance essentially reduces the maximum potential loss that the primary insurer could face, ensuring their survival even during tumultuous times. It also enables insurers to undertake more significant risks and offer higher coverage limits to their clients while maintaining their solvency position.
Examples
1. Catastrophic Events: One of the most common examples of Excess of Loss Reinsurance is in catastrophic events such as hurricanes, earthquakes, or floods. For instance, a primary insurance company responsible for homes in a coastal area may have a policy limit of $1 million. However, if a hurricane hits and causes $5 million worth of damages, the Excess of Loss Reinsurance would cover the additional $4 million. This type of reinsurance is crucial for insurance companies operating in areas prone to natural disasters.2. Terrorism: In the aftermath of events like the 9/11 terrorist attacks, insurance companies face significant losses. An insurance company may have a policy limit of, let’s say, $10 million for property damage. In case of such an event, the damages are likely to far exceed the limit. The Excess of Loss Reinsurance would kick in to cover the additional cost, protecting the insurance firm from financial ruin.3. Industrial Accidents: Industrial accidents like oil spills or nuclear accidents can result in liabilities far surpassing the policy limits of a typical insurance policy. For example, an oil company might have liability of $100 million, but the Deepwater Horizon oil spill in 2010 resulted in damages amounting to billions of dollars. Here, an Excess of Loss Reinsurance would cover these excessive costs after the primary insurer’s liability limit has been reached.
Frequently Asked Questions(FAQ)
What is Excess of Loss Reinsurance?
Excess of Loss Reinsurance, also known as XL Reinsurance, is a type of reinsurance in which the reinsurer is responsible for covering losses that exceed a specified limit. It can be used to cover a single specific risk or to protect against cumulative losses.
How does Excess of Loss Reinsurance work?
In an Excess of Loss Reinsurance contract, the reinsurer indemnifies the ceding company for losses that exceed a specified limit. This limit can be applied on a per risk excess of loss basis, per occurrence/excess of loss basis, or on a cumulative loss basis over a specified period.
What’s the difference between Excess of Loss Reinsurance and Proportional Reinsurance?
The key difference lies in how risk is shared. In Excess of Loss Reinsurance, the reinsurer only pays when losses exceed a pre-set threshold. In Proportional Reinsurance, losses are shared proportionally between the insurer and reinsurer.
When will an Excess of Loss Reinsurance policy respond to a claim?
An Excess of Loss Reinsurance policy responds when the ceding insurer’s losses on a specific risk, event, or accumulated losses over a period, exceed a specified retention limit set out in the reinsurance contract.
What are the benefits of Excess of Loss Reinsurance?
Excess of Loss Reinsurance provides the ceding company with financial stability by restricting potential losses, and reduces the amount of capital needed to underwrite risks. It also allows insurers to write larger policies than their own financial strength would normally permit, widening their potential field of operations.
Are there variations to Excess of Loss Reinsurance contracts?
Yes, there are multiple types of Excess of Loss Reinsurance contracts. They include Per Risk XL (for single risks), Per Event XL (for catastrophic events), and Aggregate XL (that cover accumulated losses), among others.
What is the purpose of the retention limit in Excess of Loss Reinsurance?
The retention limit is the level of loss that a ceding insurer is willing to retain for its own account. Once this threshold is met, the reinsurer begins to pay on losses. Setting a retention layer is a strategic decision made by the insurer based on its financial strength, risk appetite, and the cost of reinsurance.
Related Finance Terms
- Stop Loss Ratio
- Reinsurance Premium
- Ceded Reinsurance
- Attachment Point
- Risk Retention
