More Porridge Please: Reinstatements in Reinsurance
December 2011
In a typical reinsurance
contract, the reinsurer agrees to indemnify the ceding insurer
up to the stated limit of reinsurance coverage. Depending on the
type of reinsurance contract and the coverage that is provided,
that limit could be on a per occurrence or per risk basis, or it
could be in the aggregate, or it could be some combination of
limits.
by
Larry P. Schiffer
Dewey & LeBoeuf LLP
The reinsurance limit may include defense costs, or defense
costs may be outside the stated limit of the reinsurance
contract. There may be what is called a sublimit for certain
special risks, like windstorm or earthquake, which comes within
the overall aggregate limit of the reinsurance contract if there
is one. At the end of the day, a reinsurer generally tries to
limit its liability under the reinsurance contract to an
ultimate limit after which the reinsurer's liability terminates
(at least on a per occurrence or per risk basis if an aggregate
limit is not contained in the contract).
The Problem
So, what happens when the ceding insurer has ceded the
maximum dollar amount of losses to the reinsurer under the
relevant reinsurance limit? If the reinsurance agreement has an
aggregate limit, without any relief in the reinsurance contract,
the ceding insurer is now essentially without reinsurance and
must bear the remaining losses on its own if it does not have
additional reinsurance protection for those losses. Where the
reinsurance agreement has a per occurrence limitation, the
ceding insurer becomes responsible to bear the loss that exceeds
the per occurrence limit on its own for losses arising out of
that occurrence and is left without reinsurance on additional
claims arising out of the same occurrence should the occurrence
limit be exhausted by other claims. The ceding insurer only gets
the reinsurance limits it pays for, but no ceding insurer wants
to run out of reinsurance protection if it can help it.
Typically, as the reinsurer pays losses ceded to the
reinsurance contract, the limit of the reinsurance contract
depletes. Once the payment of losses reaches the limit, there is
no more reinsurance recovery available. Just like an insurance
policy exhausting its limits, a reinsurance contract with a per
occurrence or aggregate limit may exhaust as well. This
exhaustion of limits could occur midyear, leaving the ceding
insurer without reinsurance protection for the remainder of the
year. If the ceding insurer has no excess or catastrophe
reinsurance covering the same losses, the additional losses will
be kept net by the ceding insurer. This may play havoc with the
ceding insurer's finances.
In the property reinsurance arena, this could be particularly
problematic. A property treaty written on a per occurrence basis
could have its limits exhausted very easily by an accumulation
of claims arising out of one occurrence. Under those
circumstances, the ceding insurer would have no ability to cede
additional claims arising out of that same occurrence. Where
there is a likelihood of an accumulation of a significant number
of individual claims arising out of the same occurrence, a
ceding insurer would want to have the ability to reinstate the
per occurrence limit.
The Solution
One solution to running out of reinsurance limits is to
insert a clause that automatically or permissively allows the
limits to reset once exhausted. This is called reinstatement.
Often, the limit will replenish only after it is fully exhausted
and only for the remainder of the contract period. The
replenishment of the limit (the reinstatement) may be a one-time
right, may require a premium payment (a reinstatement premium),
or may trigger on the request of the ceding insurer and the
agreement of the reinsurer.
Reinstatement typically has no application to a proportional
or quota share reinsurance contract, which typically is based on
a percentage of sharing premiums and losses between the ceding
insurer and the reinsurer. Reinstatements are more common in
property reinsurance contracts written on an excess basis,
although they do appear in other contexts. In fact, Strain
defines reinstatement as:
The restoration of the reinsurance limit of an
excess property treaty to its full amount after payment by the
reinsurer of loss as a result of an occurrence.
Robert W. Strain, ed.,
Reinsurance (Strain Pub. & Seminars Inc., 1997),
Glossary.
The applicability of reinstatement to property treaties
written on a per occurrence basis makes sense. An occurrence
(e.g., an earthquake) often generates multiple individual
claims. An occurrence limit can easily be wiped out by large
numbers of individual claims, leaving the ceding insurer without
reinsurance coverage for those claims arising from the same
occurrence that are ceded after the occurrence limit is
exhausted. A reinstatement clause allows the per occurrence
limit to reset and pick up those additional claims under that
same occurrence (of course limited to the new reinstated limit),
which otherwise would not be reinsured under that reinsurance
contract.
In some property reinsurance contracts, reinstatements are
provided for free and can apply as many times as necessary. In
other reinsurance contracts, one reinstatement is allowed
subject to the ceding insurer paying the reinstatement premium.
The number of reinstatements allowed, the cost of those
reinstatements, and the manner in which the reinstatement will
be applied is all subject to negotiation.
Reinstatement Clauses
A wide variety of reinstatement clauses are used in the
industry. Typically, ceding insurers will want at least one free
reinstatement of the reinsurance limit. In many cases, one free
reinstatement is given based on tradition, market power, and
long-standing business relationships. Reinsurers, of course,
would prefer to have an additional premium paid for any
additional restated limit. In some cases, a reinstatement clause
is not needed because the limits automatically reset for each
occurrence. But where there is the risk of exhausting the per
occurrence limits because of multiple losses arising out of the
same occurrence, ceding insurers would want the ability to
reinstate the limits.
The Brokers and Reinsurance Markets Association (BRMA) has
drafted a series of reinstatement clause examples (BRMA 41) on
its publicly available draft contract wording listing. BRMA 41A
is set out below:
In the event of a claim under this Contract, it is
agreed that the amount of liability hereunder is reduced from
the time of the occurrence of the loss by the sum payable on
such a claim. However, the amount so exhausted is immediately
reinstated from the time of the occurrence of the loss.
For each amount so reinstated, the Company agrees to
pay an additional premium calculated at pro rata of the annual
earned reinsurance premium hereon, being pro rata both as to the
fraction of the face value of this Contract (i.e., the fraction
of $_____ ) so reinstated and as to the fraction of the
unexpired term hereunder at the time of occurrence.
Nevertheless, the liability of the Reinsurer shall not exceed
$_____ in any one loss occurrence, nor $_____ in all in any one
contract year.
This clause allows for one reinstatement with a premium paid
on a pro rata basis. There are many ways to calculate the
reinstatement premium based on the face value of the contract,
based on the amount of the limits, and based on the time
remaining on the contract. The clause also has an aggregate cap
on the amount that can be ceded and paid on any one occurrence
during the contract year.
A reinstatement clause should make clear whether there is a
premium being charged for the reinstatement and, if so, the
basis for the calculation of the premium. It should also make
clear whether multiple reinstatements will be allowed or whether
only one reinstatement is permitted.
Conclusion
In property excess reinsurance, allowing the ceding insurer
to reinstate the reinsurance limits is typical. What is not
typical is the number of reinstatements allowed, the cost of the
reinstatement, and the manner in which the reinstatement premium
is calculated. Clear contract wording and careful negotiation to
obtain the reinstatement needed for the risks reinsured is the
key to managing a reinsurance contract and making sure the
ceding insurer has the proper reinsurance coverage.
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