It has been suggested that the excess of loss treaty method was invented in response to a request from an insurer for a simpler product than those then existing. The aim was to reduce administration and the need for bordereaux and monthly accounts while still protecting the insurer from the effects of “a single great conflagration”.

The principal thoughts and intentions behind excess of loss reinsurance have remained the same since then. However, there have been numerous changes and developments. Excess of loss treaty business has now developed into specific made-to-measure solutions for individual client needs. It continues to evolve and develop.

The Insurance Institute of London's report Developments in Excess of Loss Reinsurance1 highlights some of the crucial events that have affected the excess of loss market. For example, the disaster of the LMX spiral provided the catalyst for a dramatic change to the environment and the opportunity for many new markets to emerge, in particular catastrophe specialists with the capital and knowledge to fill the newly created gap in the market.

The report also reviews motivations for selling or buying excess of loss reinsurance.

  • One of the main selling arguments is the reinsured's ability to budget reinsurance costs. Excess of loss premiums are usually fixed for the period of the policy and tend to be more stable at renewal. This was certainly the case for the 2000 renewals where the European storms arrived too late to change the soft but stable environment.

  • While reduced administration costs were always meant to be a principal driver behind the development of excess of loss, the spiral problems suggest these are not always guaranteed.

  • Portfolio management may be another driver behind the development of excess of loss. A ceding company that achieves success in pushing its clients to improve risk management to reduce the attritional loss ratio may opt for an excess of loss reinsurance protection because it is convinced that it is writing a good quality book of business with not too many losses. It retains a substantially higher share of own premium income (and ensuing investment income) while still providing cover for catastrophic losses. However, it must also take into consideration external influences such as market conditions or the class of business involved.

    The report's author Chris Dudley says that excess of loss should always be a useful tool, no matter whether the market environment is hard or soft since the motivation for buying this cover very much depends on the specific needs of the reinsured at the given time.

    In a hard market with scarce capacity, excess of loss protection can provide a company with the means to be competitive for the large and very large risks. It enables the company to avoid co-insurance placements and the risk of losing the account to a competitor. As rates are high, the reinsured can afford to buy this additional capacity while the reinsurer, on the other hand, can offer the cover at terms that ensure a technical profit.

    Conversely, in a soft market, excess of loss is often used to save costs. When rates are already low and margins continue shrinking, the reinsurance manager may be asked to reduce costs to improve the net result - particularly if there have not been any major losses for a certain period. Management may not appreciate giving away a significant share of their premium income for proportional reinsurance when they have not got any claims that they can recuperate.

    Class of business is an important factor in the decision to buy excess of loss protection. The report says that certain classes of business are better suited to excess of loss protection than others, with special considerations applying to any unlimited liability business such as motor third party bodily injury.

    The report stresses that, despite the trend to move towards alternative methods of providing reinsurance the traditional treaty and facultative structures will continue to play an important role. However, it points out that, as one important difference between traditional and financial reinsurance is that the reinsurer's profit on a financial risk is not necessarily dependent on the claims made under the contract, it is understandable why many companies are striving to promote this product.

    During the late 1980s and 1990s, the use of finite reinsurance grew. A large part of the world's reinsurances is now dealt with in this alternative way, no longer relying on the principle of mutualisation based on the law of large numbers; instead it seeks diversification of risk over time and over different types of exposure in a portfolio.

    Alternative forms of reinsurance have not wholly replaced treaty and facultative reinsurance despite some predictions to the contrary when they first emerged. Instead, the gap between alternative and traditional methods has shrunk. Sometimes, it is almost impossible to define a contract as one or the other.

    The most common structures we see today in this respect, says the report, are the multiline/multiyear products. “Under that term, one can find almost everything from a simple combined property and casualty placement to the most sophisticated finite deal.” Thus, alternative and traditional methods are moving closer together, complementing rather than competing with one another.

    The report also identifies a consequent change in the factors that contribute towards determining a soft or hard market. Previously, the cycle was exclusively geared by the number and severity of losses. Now, the development of the financial markets plays a very important role too. The importance of alternative risk financing in today's reinsurance markets makes investments and re-investing of premiums very important, strongly influencing the amount of capital available.

    The continuing softening of the reinsurance markets has also made investment results more important for traditional reinsurers. Strategic investment of premium income and capital base can enable a company to prosper despite negative technical underwriting results. Some companies have made this cash flow underwriting approach their business strategy to survive the soft market cycle.

    Despite some suggestions from Lloyd's that rates have hardened, the report's author says that this does not appear to accord with anybody else's experience “and may be more an attempt to talk up the market or encourage reluctant investors”.

    In addition to rating aspects, the report discusses other important factors, such as layer definitions, clauses, wordings, aggregates and reinstatements. It points out that clauses, if not worded properly, can sometimes be very misleading and interpreted in different ways.

    For example, following the winter storms Lothar and Martin in December 1999, there were heated discussions among (re)insurers in France as to whether this was one event or two. The French event wording and hours clause were not specific enough. The French market has now formed a working group to re-define the clauses, which will be applied in the future.

    The report gives extensive information on various clauses and case studies on the legal aspects, highlighting the importance of the wording of a contract.

    1 Developments in Excess of Loss Reinsurance, a report by Advanced Study Group No 244 of the Insurance Institute of London, is available from the assistant secretary, Insurance Institute of London, 20 Aldermanbury, London EC2V 7HY, UK. Price: £32 for IIL members quoting their PIN number, £42 for non-members.

  • Alison Craig is a freelance insurance journalist.