Excess of Loss Re-Insurance

The short-term insurance industry is all about risk. Insurance companies need to take on a balanced portfolio of risk to ensure that business is not crippled by one huge loss or a catastrophe. Short-term insurance is operated as a business and a business needs to be profitable to survive.

So how do insurance companies balance their risks?

Long established insurance companies would have learned through experience what the average and maximum loss is on any given risk type, for example car insurance. When new insurers start out in the business they do not have this experience to fall back on.

In South Africa we have strict legislation laying down rules and regulations to control the way an insurance company runs its business. The maximum risk that an insurer can take on will be limited by the amount of reserves it has available as it needs to maintain minimum reserves as prescribed by law.

Short-term insurance deal with the wellbeing and the money of the public at large and therefore the government has found it necessary to protect the interests of the public through legislation.

Re-insurance as a way of spreading the risk

Insurance companies use re-insurance as a way of transferring part of the risk to another insurer. In simple terms it means an insurance company takes out insurance with another insurance company for the amount of risk that exceeds the maximum risk he is prepared to carry.

Re-insurance therefore allows an insurer to take on a larger risk than it would be able to do under normal circumstances. There are different types of re-insurance such as proportional re-insurance, non-proportional re-insurance, stop loss re-insurance and excess of loss re-insurance. We will concern ourselves with excess of loss re-insurance for the rest of this article.

When do insurance companies use excess of loss re-insurance?

Excess of loss re-insurance is taken out for individual risks – where the insurer expects a number of losses each year. For example short-term insurers that deal in car and household insurance know from experience that they will receive claims for losses in these categories every year.

The insurer will decide what the maximum amount is that he is prepared to carry per risk (such as fire, theft) and per incident. This amount is called the retention. The insurance company will pay out any losses that are less than his retention amount. Should a specific loss, or the total losses, exceed the retention amount the balance of the losses will be paid out by the re-insurer.

How much excess of loss re-insurance is enough?

If large amounts of insurance are involved insurers can take out re-insurance with more than one re-insurer. It is referred to as layered re-insurance where various re-insurers take on different layers of risk cover. The premium for each layer will vary according to the amount of cover but also the level of layer. If there are three layers the last layer will only be affected if losses exceed all the limits of the previous layers. Let’s use an example to explain this concept of layering:

Layer Insured Amount Premium
3rd Layer R3 000 000 R1 500 000
2nd Layer R2 000 000 R2 000 000
1st Layer R1 000 000 R4 000 000
Retention R500 000 R10 000 000

The R10 000 000 premium that the original insurer has received represents the total premiums received from its clients. Many more losses will occur within the retention limit and very few, if any, will be large enough to reach the 3rd layer of re-insurance.

Note: These figures are only used for illustration and are fictitious.

Catastrophe excess of loss re-insurance

The example that always comes to mind when we talk about catastrophe is 9/11. But closer to home our local insurance industry also has to deal with catastrophes. Lately, with the change in global climate, insurance companies seem to be dealing with catastrophes on a regular basis, certainly more than in the past. Major flooding will always result in huge claims and the only way insurers can protect themselves against this is by using excess of loss re-insurance. Here we can also think of the major damage caused by fires in the Western Cape in recent months.

From the examples above we can see that excess of loss re-insurance is one of the ways in which an insurance company can ensure its survival in a very difficult, unsure and unpredictable market. Can we indeed, imagine an economy without the insurance industry?