By Joe Chvasta, JD, CPCU

Recently, I had the opportunity to compare claims scenarios of an excess of loss proposal with a quota share proposal for the liability coverage of our captive risk association. The results surprised me.

Excess of loss is a form of non-proportional reinsurance in which the reinsurer indemnifies the ceding company for losses that exceed a specified limit. In some cases the reinsurer is responsible for all losses over a certain amount and in other cases, such as ours, the reinsurer’s losses are capped at a percentage of losses.

Quota share is a proportional reinsurance in which the reinsured and reinsurer share insurance liability, premium and losses beginning with the first dollar of loss.

When we were presented an excess of loss and a quota share proposal for the same program, I assumed that we would just go with quota share. Without comparing the two proposals I automatically assumed the quota share proposal was better as it is proportional reinsurance and the reinsurer will pay its share of the losses (90% in this case) no matter how many or how large. I understood that we could not lose money with quota share but we could with excess of loss if the losses were high enough. It seemed to be an easy decision. Then I did the loss scenarios and it wasn’t so simple. Excess of loss was the better reinsurance if we could ensure that the loss ratio stayed low, typically below fifty percent.

The excess of loss and quota share proposals we received were not uncommon for a liability program.

The quota share option had the cedent or insured company retaining 10% and the reinsurer assuming 90% of the liability and receiving 90% of the premium less the ceding commission. The ceding commission was only at 22% as the class of business is considered challenging but it did increase to 25% if the final loss ratio was below 40%. The premium retained by the insured company consists of the ceding commission and the company’s share of the premium after losses.

The excess of loss proposal had an attachment point of $100,000, a minimum premium of 20% and a maximum of 65%. The loss adjustment factor was 10%. The reinsurer’s aggregate maximum loss was 300%. The premium retained by the insured company is calculated after losses paid within the attachment, the minimum premium and losses paid by the reinsurer including a 10% adjustment expense, up to the maximum premium.

Along with our actuary I worked up a number of loss scenarios comparing the two proposals. We used loss ratios, ground up, of 20%, 40% and 60%. All scenarios assumed $2,000,000 of premium and that 20% of losses were paid in the first $100,000.

Comparison 1: Excess of Loss vs. Quota Share, 20% loss ratio. No loss to reinsurer’s layer and $400,000 of losses below attachment

Excess of loss

$2,000,000 gross written premium

Less: Minimum premium $400,000

Loss within the attachment 400,000

Loss to reinsurer 0

Retained by Insured $1,200,000

Quota share

$2,000,000 gross written premium

Less 400,000 losses

$1,600,000 premium net of losses

Profit to Insured (10% of net): $160,000

Cede commission to Insured: 450,000 25% of 90% GWP

Retained by Insured $610,000

Result at 20% loss ratio: Excess of loss allowed the Insured to retain $590,000 more than the quota share.

Comparison 2: Excess of Loss vs. Quota Share, 40% loss ratio. One loss at $500,000 and $400,000 of losses below attachment.

Excess of loss

$2,000,000 gross written premium

Less: Minimum premium 400,000

Loss within the attachment 400,000

Loss to reinsurer 440,000 *

Retained by Insured $760,000

*($500,000 loss less $100,000 included in attachment) *1.10 loss adjustment

Quota share

$2,000,000 gross written premium

Less: 800,000 losses

$1,200,000 premium net of losses

Profit to Insured (10% of net): $120,000

Cede commission to Insured: 396,000 22% of 90% GWP

Retained by Insured $516,000

Result at 40% loss ratio: Excess of loss allowed the Insured to retain $244,000 more than the quota share.

In the third and final comparison with a 60% loss ratio, quota share is more profitable to the Insured than excess of loss.

Comparison 3: Excess of Loss vs. Quota Share, 60% loss ratio. Two losses at $500,000 each and $400,000 of losses below attachment.

Excess of loss

$2,000,000 gross written premium

Less: Minimum premium 400,000

Loss within the attachment 400,000

1^ST Loss to reinsurer 440,000 *

2^ND Loss to reinsurer 440,000 *

Retained by Insured $320,000

*($500,000 loss less $100,000 included in attachment) *1.10 loss adjustment

Quota share

$2,000,000 gross written premium

Less: 1,200,000 losses

$ 800,000 premium net of losses

Profit to Insured (10% of net): $80,000

Cede commission to Insured: 396,000 22% of 90% GWP

Retained by Insured $476,000

Result at 60% loss ratio: Quota share allowed the Insured to retain $156,000 more than excess of loss.

In conclusion, neither excess of loss or quota share proposals should be dismissed without reviewing likely claims scenarios. The insured company should work with their actuary to determine the most likely loss scenario for the entire program. In addition, when excess of loss is being considered the actuary should project how much loss is below the attachment point and the sole responsibility of the insured company. There are valid concerns with reinsuring liability programs with excess of loss reinsurance as in some cases the reinsurance would max out leaving the insured company on the hook. It is also possible that before the excess of loss reinsurance maxes out that the insured company could pay out more premium than it received.

On the other hand, as non-proportional reinsurance, excess of loss allows the insured to benefit much more than quota share if the losses turn out to be low. Both loss scenarios at 20% and 40% demonstrated this. Only the 60% loss scenario resulted in more premium to the insured company and the difference was not great.

Only after knowing all of the terms and conditions of the alternative proposals and being comfortable with the actuarial loss projections can an insurance company make an informed decision if the potential rewards of excess of loss reinsurance are worth the potential downside. In our case we decided in favor of the excess of loss proposal.

Excess of Loss or Quota Share Reinsurance When Excess of Loss is the Better Bet

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