What is a vertical cover?

Reinsurance tutorials #8 • The Basics

What is a vertical cover?

Non Proportional reinsurance is an alternative to Proportional reinsurance to protect against:

• big individual risk losses and/or huge CAT events involving many risks, the vertical covers called Excess of Loss contracts (XL) 
• increased loss frequency putting at risk your retention and balance sheet on one or several Lines of Business. These are the horizontal covers called Stop Loss and aggregates 

How do vertical covers work?

The criteria used is the size of the loss you, as an insurer, can sustain on one risk or one event damaging many risks, not the sums insured. The company fixes an amount whereby it keeps 100% of the loss below that priority or excess point and cedes 100% of the loss above the XL.

Let’s take an example to differentiate PPP and NP. Suppose:

• A gross capacity of 10 million, a retention of 1 million, a risk of 10 million and a 500,000 loss.
• If a proportional treaty gives a capacity of 9 million or 90% of the risk, you pay 90% of the premium. For a 500,000 loss on that risk, the proportional reinsurer will pay 90% of the loss, i.e.:  450,000. 
• An Excess of Loss contract gives you a capacity of 9 million in one or several layers (for example 4XL 1, then 5 XL 5). His price will only be a certain % of your premium, but where a 500,000 loss is under the priority line, the XL reinsurer will not pay anything.

Advantages/Disadvantages

• RISK XL: The Insurer is protected against peaks for a smaller amount of Gross Premium (bearing in mind that for proportional contracts the actual balance/cash you cede is after commission).
• The underwriting quality of the risks and their pricing is usually less detailed than with a proportional contract.
• CAT XL (Nat Cat): will provide you with a bigger capacity than a proportional treaty.
• CAT XL: protects against the accumulations of losses. The contract (wording) needs a clear event definition: what is covered, hour clauses telling how long you can accumulate the losses. This requires hard work and can bring about much conflict.
• CAT XLs are also used to cover against unknown accumulations (marine cargo, motor damages, personal travel accident, fire conflagration…).
• Proportional means partnership, the volatility of the reinsurance price and of the capacity offered will be much less than on NP which is a security for your budget and business plan. Price may look higher than NP, although it depends on the years, books, etc. 

NP PRICE: a fixed % (sometimes a variable one on frequency layers) of the premium income of the protected book (the Subject Premium Income). It will depend on: 

• The level of the excess point, a low level means a big probability for the XL to be affected, one or several times, if the insurer has asked the cover to be reinstated after the occurrence of a first loss, the higher the price.
• The exposure of the XL: how many risks may impact the programme.
• The claims experience over the past years.
• The probability estimated for future occurrences, the return period calculated for CAT.

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