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10/4 M97/February 2018 Reinsurance

A2 EML
Calculation of retentions based on the sums insured for separate risks is modified by the concept
of EML.
EML
EML can be defined as ‘an estimate of the monetary loss which could be sustained on a single risk as a result of a
single fire or explosion considered by the underwriter to be within the realms of probability’.

This concept considers the possibility that maximum loss will be less than the sum insured.

Example 10.2
A fire policy has a building sum insured of £1m. The insurer’s retention for such a risk, based on the sum insured, is
£750,000. The insurer’s underwriter ascertains that the building is divided into two separate units with values of
£600,000 and £400,000. If the unit with the higher value (the ‘target’ risk) is totally destroyed, the underwriter’s
liability, or EML, is unlikely to exceed £600,000. In the knowledge that the sum insured is unlikely to be paid in full as
a result of a loss, the underwriter can accept and retain the whole of the sum insured of £1m. Similarly, the EML may
be less than the sum insured since the nature of the risk is unlikely to lead to a total loss.

Therefore, the concept of EML allows the insurer to consider its expected exposure in relation to its
theoretical one, and to adjust its acceptance and its retention accordingly. More complex situations
include where, say, the EML has to take into account the existence of an insured’s material damage and
business interruption policies, or where the risk is spread out over a wide geographic area. The material
damage policy of a large industrial company may insure all buildings and machinery worldwide in one
sum, and naturally the insurer will be anxious to find out the EML in relation to the risk with the highest
values – the target risk.
A key issue in arriving at retentions and for the calculation of EML in particular, is the definition of a
A key issue is the
definition of a single risk. A building standing on its own in isolation is clearly a single risk. However, separate
single risk buildings of normal, incombustible construction not separated from each other either by an open space
of at least 15 metres, or if adjoining, by a perfect party wall, may be considered to be a single risk. Thus, Reference copy for CII Face to Face Training
several buildings on a site may constitute a single risk. Reinsurers usually accept the reinsured’s
definition of a single risk, although there is no standard definition.
The calculation of EML will also reflect the insured peril; for example, flood may present a much greater
EML in a particular risk location than the peril of fire.

A2A EML error

Difficulty arises when the EML has been miscalculated, known as EML error, and results in a higher loss
Difficulty arises when
the EML has been than was anticipated; for example, if the fire spreads to all parts of the property, or the amount of
miscalculated, known damage in one part has been greater than expected. In example 10.2, the resultant fire damage turns out
as EML error
to be £800,000 and in such circumstances the reinsurer’s liability is also greater than it would have
been than if the retention had been based on sums insured. For this reason, some underwriters now
base their retention, not on the probability that the EML will be less than the sum insured, but on the
EML itself. In the example therefore, the retention based on EML would have been £600,000.
Correspondingly, the insurer would accept less of the risk on offer, in order to ensure that its actual loss
would not exceed its retention.

Question 10.2
What are the implications for a proportional reinsurer if the reinsurance has been fixed on a ‘sum insured’ basis, but
the EML for a particular risk is underestimated?

For risk excess, the reinsurer is liable for the increased amount of loss that falls to the layer. For
catastrophe excess of loss, unless there is a limitation, the increased net retention on account of the
10 error will aggregate with other net retentions arising from the same event. If the EML error is substantial,
Chapter there may be some argument as to whether this was a material misrepresentation and could lead to a
dispute over coverage of the risk.