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Chapter 3 Features and operation of facultative reinsurance 3/9

Question 3.4
Refer again to figure 3.2.
a. If reinsurer C, shown on the horizontal axis, accepts a deductible of 25% of the sum insured, estimate the
premium equivalent of the original premium income, as a percentage, shown as D on the vertical axis, that it
would require for its participation.
b. Estimate the size of the deductible as a percentage of the sum insured that reinsurer E, shown on the horizontal
axis, is prepared to accept, and the premium equivalent of the original premium income, shown as F on the
vertical axis, as a percentage, that it would require for its participation.

The shape of the curve in the example must be carefully calibrated, taking into account many factors Chapter
such as actual loss frequency and size, construction, EML level, sprinkler protection, use and occupancy 3
and so on. Should the curve be inaccurately compiled, any subsequent allocation of premium might be
inaccurate and leave some reinsurers with too much or too little premium.
If the risk is to be reinsured in a number of layers, as in the case of our food processing plant, then the
premium for each layer can be determined by taking the difference between the premium due for the
various levels of deductible. Figure 3.3 explains this in more detail.

Figure 3.3: Premium of each layer

100%

% of If the amount of reinsurance required
premium = the difference between A and X
income then the % of the premium for that exposure
= the difference between B and Y
B
Y Reference copy for CII Face to Face Training

0% A X 100%
Total value of risk
or reinsurance

We can see that the layer of cover represented by the gap between A and X on the horizontal axis needs
to be funded by a level of premium equivalent to the gap between Y and B on the vertical axis. To place
approximate figures on this assumption, we can say that the cost of this £10 m (A to X) layer of cover will
cost 15% (Y to B) of the total premium.
Although we are using examples that relate to material damage risks, liability classes of business are
also placed on a facultative excess of loss basis and the relationship between the levels of deductibles
and the reinsurance premiums due will be similar.
Bear in mind that our comments may reflect one underwriter’s view of the link between premium and
risk. Others may have different opinions which would affect the shape of the curves shown in figures 3.2
and 3.3. Nevertheless, the principle remains the same.

Activity
Using the graph in figure 3.3 as a template, draw a right angle, similar to A to B, that represents a third layer of cover
sitting about X. Assess the approximate value of the cover provided by your layer and the premium attributable to it.

In every case, the underwriters must aim to obtain a premium that is sufficient to cover the anticipated
Underwriters must
cost of claims together with commissions (brokerage) payable to brokers and other intermediaries plus aim for a premium
other business acquisition expenses. It may also be prudent to make some form of allowance or loading that covers the
anticipated cost of
in respect of their own expenses. claims
We have previously suggested that facultative reinsurance business is a useful supplement to other
forms of reinsurance and this is certainly true of facultative excess of loss. Let us consider how it can be
used in tandem with facultative proportional reinsurance to give the insurer more choice of exposure
patterns.