Unlike proportional reinsurance, under non-proportional reinsurance (also known Excess of Loss business), no risk and premium proportional distribution is effected at the beginning of the year. Instead, it operates on quantum of actual loss, not on size of risk. Non-proportional reinsurance is structured in layers as shown in Diagram 1. The direct insurer will pay any loss up to a certain limit, called the priorityor deductible, represented by the lowest block in the diagram. All layers above the priority form the protection provided by reinsurers.
A reinsurer may either participate in all layers or select certain layers and avoid others. The number of layers, monetary size of each layer and the priority level are pretty much a combination of the direct insurer’s requirements and its appetite for risk, nature and profile of the risk or portfolio being protected. The price to be paid by the reinsured will be computed by the reinsurer applying actuarial and risk models.
The reinsured will participate in each and every loss, but the maximum amount is limited to the amount of priority. Reinsurers of the first layer will only be liable if the loss exceeds the priority, for the amount above the priority up to the upper limit of the layer. The second layer will respond only if the loss exceeds the upper limit of the first layer, and so on. For example, the reinsured has to pay the whole of Loss No. 1 shown in Diagram 1 as it is within the priority. For Loss No. 2, the priority and first layer have to pay up to their maximum liability, but the second layer is only partially affected. The third layer and all other layers above it will not have any involvement for this particular loss.
Diagram 1. Structure and Loss Allocation of Non-proportional reinsurance
For each layer, there is no proportional relationship between premium amounts paid by the reinsured and the size of a certain layer in relation to the total protection of all layers. Instead, it is determined by the probability of each layer being affected by losses, based on factors such as frequency, severity and exposure at risk.
Normally, excess of loss premium is expressed as percentage of the premium income received by the insurer on the protected portfolio. The reinsurers set the premiums at an adequate level to cover their expected claims, expenses and margin. They do not take any portion of expenses incurred by the reinsured, therefore no reinsurance commission is returned.
Adopted from Akoob, M. (2008). Reinsurance and Retakaful. In S. Archer, R. Karim, & V. Neinhaus, Takaful and Islamic Insurance: Concept and Regulatory Issues. Singapore: John Wiley & Sons (Pte) Ltd