Reinsurance Tutorials #12 - Season 2
Hi everybody 👋
Today we will focus on proportional and non-proportional Cat treaties.
We talked about Cat events and the challenges they represent for the industry in terms of the increasing number of events, exposure and the role of the reinsurers who must address these issues.
However, the reinsurers (like the insurer) closely monitor their exposure to determine their maximum liability in the event a catastrophe should occur.
So how is this taken into account in proportional and non-proportional treaties? What are the options?
Let’s start! ⏬
Proportional vs non-proportional treaties
As you know, proportional and non-proportional treaties do not serve exactly the same purpose.
Proportional treaties share the entire burden of written risks between the insurer and the reinsurer. Consequently, they are used to cover risks that occur frequently. On the other hand, non-proportional treaties are used to cover events of extreme intensity.
Cat events are usually covered by non-proportional programs tailored for such events. However, this doesn’t mean that proportional treaties do not contain a Cat component.
For example, when a reinsurer provides support to a company participating on a Property Quota-Share treaty, it will cede any losses affecting the underlying portfolio to the treaty. These may include simple fire losses or extreme Cat event losses. Naturally, these losses are covered on a proportional basis as defined in the wording!
To limit the reinsurer’s exposure in case too many events or very extreme events affect the treaty, the reinsurer can include one of the following clauses: Loss Cap, Annual Aggregate Limit or Event Limit.
The way these clauses work is quite simple. The Loss Cap fixes a maximal recoverable amount in the form of a percentage of the reinsurance premiums received under the contracts. This maximal recoverable amount is defined over the entire period of the contract and therefore on an aggregated basis for the period.
For example, a loss ratio cap of 300% states that the maximal amount recoverable under the reinsurance contract is set to three times the reinsurance premium received, usually over a 12-months period.
Annual Aggregate Limit (AAL)
The Annual Aggregate Limit (or AAL) is quite similar but instead of defining a cap on the basis of a percentage, the limit is based on a flat amount, for example, an Annual Aggregate Limit of 12 million euros.
An Event Limit is a bit different, as it is based on a limit for each and every event that occurs during a given period and not on an average aggregate limit for several events. For example, an event limit of 30 million euros will cap the maximal reinsurer’s liability at this amount for each event. Therefore, if the ceding company is impacted by a 35-million-euro event, then the 5 million euros over the Event Limit is not recoverable under the reinsurance treaty.
Note that loss caps are usually found in proportional treaties, but AALs or Event Limits can be found in either proportional or non-proportional treaty programs.
Speaking about non-proportional treaties, as I mentioned at the beginning of the video, they are usually the structure of choice when covering extreme hazards events, whether these are Nat Cat or man-made events.
Because of their nature, the design of excess of loss structures enables reinsurers to more easily determine their maximum exposure because the boundary between the reinsurer and the cedant is defined by a deductible and a limit, for example, 10 million in excess of 2 million. In this example, if an extreme Cat event should occur, the maximum capacity offered by the reinsurer will be 10 million.
But excess of loss is not the only non-proportional structure use(d) for Cat events. Nowadays, companies are more and more keeping a “core” excess of loss program and purchasing additional programs to protect them from the increased frequency of minor events, and protect their balance sheet in case during adverse years.
The two structures that are used most often are the aggregate cover and the stop-loss treaty.
Aggregate cover programs
Aggregate cover programs usually provide underlying protection for traditional Cat XL programs. The main difference between this type of program and a traditional Cat program is that once the sum of all the ceding company’s losses reaches the deductible, coverage will be triggered under the treaty. Then, any additional losses can be recovered through the treaty, until complete erosion of the program.
Take, for example, a 10 XS 10 million euro aggregate program. The ceding company will sum up all losses occurring during the year (as per the definition of the loss occurrence clause of the program), and if the total amount reaches 10 million, any additional losses will be recoverable through the program, up to a maximal amount of 10 million within the period.
On the other hand, a Stop-Loss Treaty is usually purchased on top of a traditional Cat XL program. The purpose of a stop loss is quite easy to understand: stop the losses! The way it works is very similar to the loss ratio cap clause mentioned earlier, as the limit and deductible of a stop loss are based on a percentage of the premium.
Let’s look at this example: 50% XS 150%. This structure could be translated by saying “If the loss ratio of the ceding company reaches 150%, then the reinsurer will pay every loss up to 50% of the cedent’s premium income”. Convenient, right? Well, it is, especially when protecting a company’s balance sheet.
Well, I hope you have enjoyed learning more about the different clauses and structures we use in the industry to monitor our exposure. In the next video, Clémence will give you more insights on the differences between Natural Catastrophes and man-made events.
Thanks for your attention!
Bye for now 👋
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