When a reinsurer is considering whether it should agree to participate in a proportional reinsurance agreement, it is basically relying on the ceding company’s pricing of its own insurance policies. If the reinsurer believes that the pricing is inadequate, it usually will not wish to be a party to the agreement. When it comes to an excess agreement, the reinsurer sets its own rate. The reinsurance rate is applied to the premiums that the ceding company is charging. If the ceding company charges amounts for its policies that are different from what had originally discussed with the reinsurer, then it will obviously change the amount that the reinsurer receives. For purposes of our discussion, we will assume that the ceding company does not change the amount it charges for its policies during the term or the reinsurance agreement.

So, what does inflation have to do with pricing an excess of loss reinsurance agreement? Let’s look at five losses from 2004. To make it simple, we will assume that all these losses were all settled in 2004 as well. The losses were $90,000, $100,000, $110,000, $120,000 and $130,000. If the company’s retention were $100,000, it would have been responsible for $490,000 of the losses and recovered $60,000 from its reinsurer.

If a reinsurer was trying to determine how much it should charge the ceding company with the same retention as in 2004, it would want to know how much it would cost if those same losses were to occur in 2009. Let’s assume that over the last five years the cost to settle those types of losses increased by 20%. The individual losses would now be $108,000, $120,000, $132,000, $144,000 and $156,000. The ceding company’s share of the losses would have increased by 2% to $500,000 while the reinsurer’s share would have increased by 167% to $160,000.

So a frequent bone of contention between the ceding company and the reinsurer is what is the proper rate of inflation to be applied to existing losses. Please note that a ceding company’s own losses are only some of what goes into pricing a program. The reinsurer would not price a program based on only five losses. The reinsurer would also use industry statistics. Tomorrow, there will be the last bit discussion of pricing.