We have seen that in proportional Treaties, the original "gross net" premiums are shared between the Reinsurer and the Cedant in same proportion to which the liabilities are shared. When it comes to Non Proportional Treaties however, the arrangement is entirely different.
There are three types of premiums involved in Non-Proportional treaties i.e Minimum and Deposit premiums, Adjustment Premiums and Reinstatement Premiums.
Minimum and Deposit Premiums (MDP's): The Reinsurance Premium charged for a non-proportional treaty is obtained by applying a percentage rate on the “Gross net Premium Income (GNPI)" for example, if the gross net premium income is 500,000.00 and the rate is 5%, The reinsurance premium will be = 5%*500,000= 25,000.00. The Gross Net Premium is the Total written premium less any cancellations, less any reinsurance premiums paid to the proportional treaties. The Reinsured cannot know for certain how much premium he will write in any given year for any given class of business. So when calculating the price for a non-prop treaty at the beginning of the year, the Reinsured will provide the Reinsurer with an Estimate of the Expected Net Premium Income. This estimate is known as the Estimated Gross Net Premium Income (EGNPI). It's on this that the applicable rate determined by the Reinsurer will be applied to come up with the Minimum Premium. Minimum because its the least premium that the Reinsurer will accept in return for the protection he will provide. Reinsurers will expect to receive this premium in advance at the start of the reinsurance period to enable them invest it hence the Deposit. The Premium therefore paid by the reinsured to the Excess of Loss Reinsurer at the start of the Reinsurance Period in advance is called the Minimum and Deposit Premium.
Though Reinsurers usually expect this premium at the beginning of the period, it’s not likely that this ever happens. Usually an arrangement is agreed upon between the reinsured and the reinsurer. If the Reinsured is prepared to pay the entire premium at inception, the reinsurers could allow a discount of up to 20%, if he decides to pay half yearly, then possibly a discount of 15% could be allowed and if quarterly a discount of up to 10% could be allowed but keep in mind that these payments are made in advance. i.e the start of each of the payment periods.
Adjustment Premiums (AP): At the end of the reinsurance period, the Reinsurer will able to ascertain how much premium he has written. Since the Minimum and Deposit premiums collected at the beginning of the year are based on estimates, the Reinsurer needs to ascertain the actual premiums to be collected from the reinsure The Actual XL premium will be calculated by applying the rate on the GNPI. The Adjustment Premium is then determined by getting the difference between MDP’s and the Actual XL premium.
If the Actual Premium is greater than the MDP, then the Reinsured will pay an additional premium to the Reinsurer. However if the Actual Premium is less than the MDP, the Reinsurer will NOT refund the difference as the MDP’s agreed at the beginning of the year were the minimum premiums.
Rates in excess of loss treaties could either be flat rates i.e. a single rate of 5% or a sliding rate between a minimum rate and maximum rate i.e. (5% -8%)
Consider the Example below.
ABC insurance company purchases and excess of loss treaty of 5,000,000 Xs 500,000 for its fire line of business for the period 01/01/2017 to 31/12/2017. The Adjustment Rate is 3.5% ABC expects to write (EGNPI) 1,500,000 during 2017.
At the end of the year 2017, ABC’s Actual Gross Net Premium Income is (GNPI) 2,000,000.00
(a)The Minimum and Deposit Premiums to be paid by ABC will be MDP’s = Adjustment Rate*EGNPI= 3.5%* 1,500,000.00= 52,500.00
(b)At the end of the year the Actual Premiums will be = Adjustment Rate *GNPI= 3.5%*2,000,000=70,000.00. The Adjustment Premium will therefore be; 70,000.00- 52,500.00=17,500.00
(c)If However the Actual Gross Net Premium was 1,000,000.00, the Actual Premium will be 3.5%*1,000,000=35,000.00. Since this premium is less than the MDP of 52,500.00, no refund will be made to the reinsured.
It’s important for the reinsured to be very careful when determining his EGNPI as he may find himself paying more than he should have as seen in (c) above
When a sliding rate is used for example (5%-8%), the Minimum and Deposit Premiums will be calculated using the minimum rate i.e 5%, when the adjustment is being done at the end of the year using the end year results. The Reinsurer will re-calculate the rate to use to determine the XL premiums. This rate however cannot exceed 8%. It has to be between 5% -8%, and if the rate is less than, 5%, then the Minimum rate applies.
Reinstatement Premiums: When an Excess of Loss treaty pays for a claim, the amount of cover provided by the treaty reduces by the amount of the claim. For example
ABC insurance company has an Excess of Loss Cover of 5,000,000 Xs 400,000. If ABC suffers a loss of 2,000,000.00, it will bear the first amount (deductible) of 400,000 and recover 1,600,000 from the XL treaty. After recovering this amount, the cover limit available will reduce by the amount of claim i.e 5,000,000-1,600,000.00 = 3,400,000. ABC therefore only has 3,400,000 amount of cover available down from 5,000,000.
This leaves the reinsured operating with insufficient protection. By paying what is known as a "Reinstatement Premium", ABC will be able to reinstate its cover back to 5,000,000.00 automatically at the time of settling a claim. And the cover is reinstated from the date of loss to the expiry of the treaty.
Reinstatement Premiums are calculated on either “prorata as to amount” or “prorata as to amount”. Let’s take a look at the examples below to explain this better.
ABC has a fire excess of loss premium of 5,000,000 Xs 400,000.00 for the period 01/01/2017 to 31/12/2017. The Annual Premium for the cover is 50,000.00. The Treaty allows 1 reinstatement at 100% additional premium. ABC suffers a fire claim of 800,000.00 on 03/04/2017. Calculate the Reinstatement Premium.
Scenario 1: Prorata as to amount:Recovery amount from the XL treaty will be 400,000.00. This means that 400,000 of the cover bought has been used up and 4,600,000.00 is left. The 400,000 used has to be reinstated to allow the reinsurer operate at full capacity. The Reinstatement Premium will be (Loss/Cover limit)* Premium = (400,000/5,000,000)*50,000*100% = 4,000.00
Scenario 2: Prorata as to time: No of days from date of loss (03/04/2017) to expiry of treaty will be 273 days. The Reinstatement Premium will therefore be (400,000/5,000,000)*50,000*100%*273/365=2,991.78
Reinsurers prefer to use prorata as to amount instead of prorata as to time because the former results in more premium. It's also less complicated and administrativley simple to administer.
With claims being paid out throughout the year, computation of premiums will be based on the Minimum and Deposit Premiums which of course are also computed on expected results. At the end of the year when the final results are obtained and adjustment premiums obtained. It’s important for the reinsurer to also adjust the reinstatement premiums using the Actual XL Premiums.
So how is the Pricing for Reinsurance Treaties done? In my next article, I will be talking about this.
