What it means
An insurer collects premiums from thousands of customers and expects most claims to be small and predictable. The real danger is the rare enormous claim, a factory fire or a hurricane, that could wipe out a year of profit in a single afternoon.
Excess of loss reinsurance moves that tail risk to a specialist buyer of risk at a fixed, known price. The cover is written in layers, usually quoted as a limit "excess of" a retention, such as $4,000,000 excess of $1,000,000.
Anything under the retention is the insurer's own problem, the reinsurer pays the slice between $1,000,000 and $5,000,000, and losses above $5,000,000 fall back on the insurer unless it has bought a second layer sitting on top. Two main varieties exist.
Per risk excess of loss responds to one large claim on one policy, while catastrophe excess of loss responds to the total of many claims arising from a single event such as a storm or an earthquake. Pricing depends on how far the layer sits above the expected loss.
Low layers that are hit most years are expensive, sometimes costing 20% or more of the limit annually, while remote top layers that are almost never touched may cost only 1% or 2% of the limit. Businesses outside insurance meet the same structure through captive insurers and large-deductible policies, where the company self-insures a first layer and buys catastrophe protection above it.
The accounting matters too, because reinsurance recoveries are recorded as an asset rather than as a reduction of the gross claim liability, so both sides of the balance sheet grow.
In practice
Real-world examples
Example 1
A regional motor insurer writes 90,000 policies and expects average claims of about $3,000. It buys $2,000,000 excess of $250,000 per risk cover so that a catastrophic personal injury award, which can run into millions, cannot destroy its capital base.
Example 2
A marine cargo insurer covers container shipments worldwide. After a vessel loss produced a $9,000,000 claim, it restructured its programme into three stacked layers so that no single sinking could consume more than a quarter of its annual underwriting profit.
Example 3
A hospital group runs a captive insurer for its own medical liability exposure. The captive retains the first $500,000 of every claim and buys excess of loss cover above that, which keeps premiums low while protecting the group's balance sheet from a rare very large award.
Think of it
Think of it like jumping on a trampoline with a safety net underneath. You can bounce normally and handle small falls yourself, but if you bounce way too high, the safety net catches you so you do not crash hard onto the ground.
Formula
Calculation
Reinsurer's payment = the lesser of (Loss - Retention) and the Limit, and never less than zero.
Take a layer written as $4,000,000 excess of $1,000,000. A warehouse fire produces a covered loss of $3,200,000. The insurer pays the first $1,000,000 and the reinsurer pays $3,200,000 - $1,000,000 = $2,200,000.
Now take a worse event in the same year, a covered loss of $6,500,000. The amount above the retention is $6,500,000 - $1,000,000 = $5,500,000, but the layer is capped at $4,000,000, so the reinsurer pays $4,000,000. The insurer carries its $1,000,000 retention plus the $1,500,000 that sits above the top of the layer, a total of $2,500,000, and $4,000,000 + $2,500,000 = $6,500,000.Case study
Seen in the real world
Northwind Mutual is an illustrative, entirely fictional regional insurer used here to show how the layer works in practice. It wrote property cover for small manufacturers, retained the first $1,000,000 of any single loss, and bought $4,000,000 excess of $1,000,000 for a premium of $620,000 a year.
In a quiet year the cover looked like wasted money, since no loss exceeded $700,000 and the reinsurer paid nothing. The following winter a storm damaged three insured sites, and one produced a covered loss of $3,200,000, of which the reinsurer paid $2,200,000. The finance director's board paper made the point plainly: across two years Northwind had paid $1,240,000 of premium and recovered $2,200,000, but the reason to buy the cover was never the recovery, it was that the worst-case loss to capital was known in advance.
Because a second event that year reached $6,500,000, Northwind also discovered the limit of its protection, absorbing $2,500,000 itself. It added a second layer above the first at the next renewal.
Watch out
Common mistakes
- Assuming the reinsurer pays the whole claim once the retention is breached, when in fact it pays only the slice between the retention and the top of the layer.
- Treating reinsurance recoveries as a reduction of the reported gross claim, rather than recording a recoverable asset alongside the full gross liability.
- Buying a layer based on last year's largest loss instead of on how much capital the business could afford to lose in a genuinely bad year.
Questions
People also ask
How is this different from quota share reinsurance?
Quota share splits every premium and every claim by a fixed percentage from the first dollar, while excess of loss only responds once losses pass an agreed threshold.
Does excess of loss cover apply per claim or per year?
It depends on the wording, since per risk contracts respond to each individual loss while aggregate and catastrophe forms respond to accumulated losses from one event or one period.
What happens if the reinsurer cannot pay?
The original insurer remains fully liable to its policyholders, which is why reinsurer credit quality and collateral arrangements are reviewed as carefully as price.