Layering Approach in Reinsurance

The business of reinsurance is to provide coverage against catastrophic events which may be caused by the wrath of nature. We are well aware of the fact that nature can be unpredictable.

Even though reinsurance companies are able to predict the timing as well as the impact of natural calamities with a high degree of precision, there is always a chance that an outlier event will cause massive damage.

Such outlier events can be black swan events meaning that they are not predictable using any statistical models. However, at the same time, they can easily lead to the bankruptcy of one or several reinsurance companies.

As a result, almost no reinsurance company wants to provide a very high coverage to the ceding insurer. However, at the same time, the ceding insurer is looking for high coverage. It is for this reason that the concept of layering has been introduced in the reinsurance market.

Layering is highly popular and almost every reinsurance policy is created with built-in layers. In this article, we will have a closer look at what layering is and what are some of the pros and cons of using layering.

What is Layering?

Layering is an approach that is used for effectively managing risks while underwriting reinsurance policies. The layering approach is used for reinsurances which are underwritten on an excess of loss basis. It also involves several reinsurers underwriting coverage sequentially.

This means that instead of the entire policy being covered by one reinsurer, different layers are created and the risk pertaining to each layer is borne by a different insurer. The ceding insurer may or may not be aware of this arrangement between the reinsurers. This is because usually when the policy is signed, the entire risk is borne by the same reinsurer. However, this risk is transferred to other parties in the secondary market using retrocession.

Example of Layering

To better understand layering, let’s have a closer look at it with the help of an example. Let’s say that a reinsurance policy has been underwritten by four different reinsurers. The terms and conditions of the policy are as follows:

• Reinsurer 1: $10 Million * $0

• Reinsurer 2: $30 Million * $10 Million

• Reinsurer 3: $60 Million * $40 Million

• Reinsurer 4: $100 Million * $100 Million

Now, the amount on the left side denotes the sum assured. This is the maximum amount that the insurer will pay for that layer of insurance. If the losses exceed that amount, then the layer will be considered to be exhausted and the next layer will come into play.

The amount mentioned on the left side can be considered to be the “excess”. This means that the losses have to reach that amount before that particular layer gets triggered.

For instance, the first layer may get triggered at any loss since the amount is $0. However, the third layer will only be triggered after a $40 million loss since $10 million and $30 million will be covered by the first and second layers respectively.

Structuring the Layers

In the case of a layered policy, the reinsurer would generally mention the premium amount with details of the breakup. They would generally provide the details of the premium charged for each layer. There are some details that need to be understood about the structure of a layered reinsurance policy.

1. Firstly, the dollar amount of losses covered in each layer generally increases exponentially. For instance, in the above example, the first layer covers $10 million, the second layer covers $30 million, the third layer covers $60 million and the last layer covers $100 million!

   This increasing coverage is tied to the statistical probability of the event happening. A small loss of up to $10 million is likely to be suffered several times. Hence, even though the impact is less, the frequency of such claims is expected to be a lot. This is the reason that this layer has a smaller sum assured.

2. The subsequent layers witness increasing coverage. This is because of the fact that the probability of such a huge loss occurring keeps on decreasing as the layers increase.

   For instance, the probability of a $40 million may be high but the probability of a $100 million loss would almost be negligent. It is for this reason that the layer after $100 million has a huge sum assured.

3. It also needs to be understood that even though the sum assured keeps on increasing as subsequent layers are reached, the related premium keeps on decreasing. Once again, this is related to the probability of a loss actually occurring.

   The reinsurer providing the lower layer of coverage would be expected to pay out more often whereas the one with the highest layer of coverage would almost never be expected to pay out claims. It is important to adjust the premium of each layer based on the probability of the event happening in order to ensure that the arrangement is fair to all the parties involved.

The fact of the matter is that layering is a very important arrangement in reinsurance. It is a great tool used to effectively manage the huge risks which arise from insuring unpredictable natural calamities. The pros and cons of this approach have been discussed in the next article.