Stop-Loss Reinsurance

What Does Stop-Loss Reinsurance Mean?

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

A reinsurance policy operates similarly to a regular insurance policy, such as one for a home or vehicle, where the insurer promises to pay for losses resulting from covered perils. In exchange for this promise, the insured pays premiums. Likewise, reinsurance policies are purchased by insurance companies to protect themselves from potential losses they may have to pay.

Like all reinsurance policies, stop-loss reinsurance is designed to protect the reinsured, which is the primary insurance company (also known as the cedent, as they cede part of the risk to the reinsurer). The reinsured pays regular premiums to the reinsurer to limit their potential exposure to large losses within a given time frame, essentially protecting them from losses exceeding a certain amount.

Stop-loss reinsurance is also referred to as excess of loss ratio reinsurance or stop-loss ratio reinsurance.

Insuranceopedia Explains Stop-Loss Reinsurance

Stop-loss reinsurance policies are sometimes purchased to:

• Improve cash flow
• Enable the company to offer more diverse coverage
• Stabilize results
• Reduce the potential for catastrophic loss
• Free up capacity to write more business

Insurance companies assume the risk of claims and potential losses each time they underwrite a policy. For regulatory reasons and to ensure financial security, there are limits on the amount of risk they can take on relative to the reserves they hold, whether voluntary or statutory.

These limits, however, restrict the amount of business they can underwrite, and consequently, the revenue they can generate from premiums. This limitation is unsatisfactory for many insurance companies, as it would require a substantial increase in their reserves to write more business.

To reduce the overall risk and free up capacity for additional business, insurers collaborate with reinsurers to offload part of the financial burden by purchasing reinsurance policies.

In this context, stop-loss reinsurance, which does not operate on an individual claim basis, helps protect the insurer from losses exceeding a certain limit over the course of a year. For example, if an insurance company’s total losses exceed 75% of its earned premiums, the reinsurer would cover the losses up to a specified limit. This is a form of non-proportional reinsurance (unlike treaty or facultative reinsurance), where the reinsurer only pays for losses above a predetermined threshold. This threshold can either be a fixed value or a percentage of premiums.

For instance, if a one-year stop-loss reinsurance policy is purchased for a portfolio of insurance risks earning $20 million in premiums with a 75% stop-loss, the reinsurer would cover any “excess” losses if the portfolio’s claims exceed $15 million.

This type of reinsurance plays a critical role in stabilizing the primary insurer’s financial results in the event of catastrophic incidents, such as natural disasters, by capping the potential payout within a specific period. By paying a relatively small premium, the primary insurer is protected from incurring a loss on their business portfolio, as losses can never exceed the premiums collected during that term.