This term is used to describe a form of non-proportional reinsurance the use of which has grown considerably during recent years.
The fundamental difference between non-proportional or excess of loss and the more traditional proportional or pro-rata form of reinsurance is that with the former there is no proportional sharing of the original risk between the ceding company and the reinsurer.
The cover provided by the reinsurer is the protection against losses over and above an agreed figure occurring within a specific account. As reinsurance, it is the most simple to operate, and for that reason, its administration costs are normally much less. In its various forms, it can supplement or even replace entirely proportional reinsurance and in the modern market, it is hard to imagine any account being written without the benefit of some excess of loss protection.
The 3 (three) most basic and currently used methods are:
1. Catastrophe excess of loss
This is the earliest form of non-proportional reinsurance and is designed to protect the ceding company's net account against a loss or series of losses arising out of one event. Catastrophe excess loss protection can be sometimes effected an a ceding company's treaty as well as their net retention.
This form of protection is principally against disasters arising out of flood, earthquake, windstorm, explosion, and conflagration. Its effect is to limit the company's loss to an agreed figure which the company feels it could afford to lose without threatening its financial stability or perhaps ruining the results of its account that year. The excess point and extent of cover vary considerably, therefore, as to the size of the company, e.g., a small company would effect say a cover for USD 50,000 excess of USD 10,000 and a large company USD 500,000 excess of USD 250,000. The covers are widely differed at but the principle is exactly the same. This is best illustrated by imaging that the small company's net retention is USD 2000 and the large company's USD 50,000. Each, therefore, has a cover for a loss in excess of live retentions. The fixing of excess points and extent of cover depends on widely differing factors for each individual company and requires a great deal of expertise.
2. Underwriting or working excess of loss
This is a more recent development in excess of loss protection and the basic idea is the same as in (a) In this form, however, the reinsurer normally provides cover against losses on a per risk basis and the excess point is fixed at a much lower level. It is essential that cover provided is used or 'worked', which is in direct contrast with (b) where the cover only operates due to unforeseen circumstances and then only rarely over for a period of many years. This form of excess of loss is designed to replace, or at least largely supplant proportional reinsurance. It is generally considered that this method of reinsurance greatly simplifies and reduces administration. There are, however, wide implications arising out of its use, not least being the suitability of the account for such a form of reinsurance.
3. Excess loss ratio or stop loss
This form of non-proportional cover differs from the other basic forms in that it protects a ceding company's account against wide fluctuations due to losses over for a period of at least a year. There is, therefore, no specific cover against a loss event but rather an undue fluctuation due to bad results in any one year.
The cover operates by the reinsurer agreeing to pay all losses over an agreed percentage of the insured's retained account up to a certain limit also expressed as a percentage, e.g., the reinsurer agrees to pay the number of losses exceeding the ratio of 70% up to the ratio of 120% of the retained account. Thereafter, the ceding company is liable for any further loss amount unless he has arranged a further or second layer 'stop-loss' cover. It is a desirable principle with this form of cover that the reinsurer does not guarantee a profit to the ceding company in the year of account.
Source:
Chas. E. Hall, FCII, FCIArb., FIAA, FBIM. 1985. Property and pecuniary insurances. The CII Tuition Service.
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