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.
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).
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.
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.
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.
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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