PROBABLE MAXIMUM LOSS - IN SURPLUS TREATY

THE EFFECT OF PROBABLE MAXIMUM LOSS UNDER SURPLUS TREATIES

Surplus Treaty is an arrangement between the cedant (insurer) and the reinsurer in which the cedant cedes risk more than his retention to the reinsurers up to the treaty capacity. Here, the cedant first decides his retention based on several factors like capital, free reserve, risk profile, demographic spread of risk, underwriting philosophy, the class of business etc. This retention is called ‘Gross Retention’. This is also called a ‘Line’. It is normally quantified in monitory terms, say 200 million.

The reinsurers offer surplus treaty capacity in multiples of ‘Lines’. For example, 25 lines Surplus Treaty – meaning that the reinsurers have offered a treaty capacity of 200*25 = 5,000 million. So, in this case, the cedant can write risks up to 5,200 million without resorting to facultative support.

Many insurers may also have a Table of Retention, which is also called Graded Down Retention. They may categorize the risks into different categories based on occupation, risk factors, underwriting appetite, location etc. For best of risks, they may retain 200 million, and gradually reduce their retention based on the quality/category of risks. For example, if there is a Chemical risk, and the insurer decides to retain only 100 million, in which case, the treaty capacity automatically gets reduced to 25 lines of 100 million, which is 2,500 million. This helps the insurer and the reinsurer to avoid exposure in respect of risks which may not fall in the preferred category or in their risk appetite. So, one needs to understand that under surplus treaty, the capacity is linked to the insured’s retention. The insurer cannot retain less and fully expose the reinsurer of the treaty capacity.

The surplus treaty arrangement presupposes the fact that the sum insured (risk) and the premium are shared proportionately. For example, if the gross retention of an insurance company is 200 million and have a 25 lines surplus treaty providing support of 2,500 million. If there is a property risk of 1000 million, the insurer will keep 200 million and reinsure 800 million under the above surplus treaty arrangement. So, the insurer will be able to keep only 20% of the premium and pass on 80% of the premium to reinsurers. The property may be an office complex which has a good risk management practice and has installed all fire protections like extinguishers, hydrant, sprinklers etc. The engineers of the insurer, after inspecting the risk, have opined that if a fire accident must happen, the property will not be affected more than 40% even under the worst circumstances. In simple terms, it means that even under the worst circumstances, the fire can be dozed off before 40% of the property is affected. This limit is called (in this example 40% of 1,000 million) the Probable Maximum Loss or Estimated Maximum Loss or Maximum Probable Loss. More the risk mitigating factors that a property has, the further the probable maximum loss will be reduced. This concept of reinsuring based on Probable Maximum Loss is called PML underwriting. If an insurer has a good team of efficient and experienced engineers, they will assess each risk before underwriting, to arrive at the PML percentage and will underwrite the risk based on the PML. PML is a technical assessment of the loss value of the risk insured in the worst-case scenario had an insured event happens. 

What is the advantage of underwriting on a PML basis?

·      The insurer will be able to retain more premium to their account.

·      The need for any facultative reinsurance can be avoided or minimized.

This can be explained by the below tables. Consider that the gross retention is 100 million and the reinsurers have offered 25 lines capacity up to a maximum of 2,500 million. The Sum Insured of a particular Property Risk is 1,000 million and the premium is 10,000,000. The PML assessment is 40%.

From the below Table 1, we can observe that if the risk is written on a PML basis then the insurers are able to retain more premium to their account. Note that in this case the reinsurer’s premium is reduced.

Take another example. Here the Sum Insured of the Property is 4,000 million and the Premium is 40,000,000.

Had the risk written on sum insured basis, there was a need for facultative reinsurance to the extent of 35%. When 40% PML is applied the entire risk is accommodated within the treaty itself.

When an insured has multiple locations, it may be sensible to write the risk on 'top location' basis as the possibilities of loss happening in more than one location is remote.

However, the biggest problem in underwriting on PML basis is when the insurer encounter a situation of loss happening more than the PML. This is called 'PML Bust' or 'PML Error'.

The PML bust could also result from the accumulation of risk as in the case of Twin Tower Loss, where the PML was taken to be the sum insured of one tower.

The treaty usually mentions the minimum PML to be adhered to. For example in the above illustration the engineers have estimated the PML is 40%. But if the reinsurers have prescribed the minimum PML of 50%, then the PML has to be treated as 50%. What is to be noted here is that the treaty only prescribes the minimum PML. In case, the actual PML of a risk is 70% then the insurer has to underwrite the risk using PML as 70% and not 50%.

To mitigate the higher exposure due to PML bust or error, the insurers resort to buying PML Error excess of loss. Many a times the Bottom Layer of the XoL cover embraces losses due to PML Bust in addition to working losses.

Now the most important question is when a risk is ceded on a PML basis, and a loss happens exceeding the PML, are the reinsurers responsible to pay the loss provided it is falling within the capacity offered. It is a very interesting scenario. While most of the times the reinsurers are liable, there may arise some dispute, for example, if the risk consists of only one block and the PML arrived is low. Either the reinsurers will increase the minimum PML at the next renewal or may insist on cessions on Sum Insured basis only.