Stop-Loss Reinsurance

What Does Stop-Loss Reinsurance Mean?

Stop-loss reinsurance is a type of excess of loss reinsurance wherein the reinsurer is liable for the insured's losses incurred over a certain period (usually a year) that exceed a specified dollar amount or percentage of some business measure, such as earned premiums written, up to the policy limit.

A reinsurance policy operates in a very similar way as a regular insurance policy anybody might purchase on their home or vehicle in order to protect themselves from financial loss should something happen. With “regular” insurance, the insurer promises to pay if an insured peril damages an object of insurance. In exchange for this promise, they are paid premiums annually. Similarly, reinsurance policies are purchased by insurance companies to protect themselves against losses they might have to pay.

Like all reinsurance policies, stop-loss reinsurance policies are designed to protect the reinsured. The reinsured is the primary carrier and is also sometimes referred to as the cedant because they are ceding – or giving up – a part of the risk to a reinsurer. The primary insurance company (the reinsured) makes regular premium payments to the reinsurance company in order to limit the amount they would have to pay within a certain time frame. In essence, they are protected from losses above a certain value.

Stop-loss reinsurance may also be known as excess of loss ratio reinsurance or stop loss ratio reinsurance.

Insuranceopedia Explains Stop-Loss Reinsurance

Sometimes stop-loss reinsurance policies are purchased to:

• Improve cash flow.

• Enable the company to offer more diverse coverage.

• Stabilize results.

• Reduce the potential for catastrophic loss.

• To free up capacity to write more business.

Insurance companies take on the risk of having claims filed and incurring losses every time they underwrite a policy. For regulatory reasons and to ensure the financial security of the firm, there are limits on the amount of risk they are able to take on relative to the amount they hold in voluntary or statutory reserves.

However, this then limits the amount of business they are able to underwrite and therefore the amount of revenue they are able to bring in in the form of premium dollars. This limitation does not sit well with many insurance companies as they would need to greatly increase their reserves in order to write more business.

Therefore, to reduce the overall risk they take on and free up capacity to write more business, they work with reinsurers to reduce risk by offloading the part of the financial burden of an insurance portfolio via purchasing reinsurance policies.

In this case, stop-loss reinsurance, which does not function on an individual claim basis, helps protect the insurer from suffering losses that exceed a certain limit over the course of a year. For instance, if an insurance company's total losses exceed 75 percent of its earned premiums, the reinsurer would pay for the losses up to a coverage limit. This is a form of non-proportional reinsurance (as opposed to a treaty or facultative reinsurance policy) in that the resinsurer only pays losses over a predetermined level. This level is either set at a fixed value or as a percentage of premiums.

For example, if a one year stop-loss reinsurance policy is purchased on a portfolio of insurance risks that earns $20M in premiums with a 75% stop-loss, the reinsurance company would pay for any additional or “excess” losses if that portfolio were to pay out over $15M in claims.

This type of reinsurance serves the important purpose of stabilizing the primary insurance company’s financial results in case of any catastrophic events like natural disasters by putting a cap on how much they might be called upon to pay out during any one period of time. In exchange for paying a relatively small premium, the primary insurer is protected from making a loss on their book of business as losses can never exceed the premiums brought in during that term.