Pricing it right: understanding the pricing of excess reinsurance can help underwriters place layered deals.

When I started working for a reinsurance company five years ago, I thought my biggest challenge would be mastering pricing techniques used in the reinsurance world. Even as an experienced primary underwriter, I was often mystified at the pricing of excess reinsurance.

Fortunately, the process of pricing this business was not nearly as difficult to learn as I had feared, and soon I was comfortable using reinsurance modeling techniques to price accounts. It is a fascinating, multifaceted process that should be considered art rather than science.

The following topics offer a fundamental understanding of the thought process for pricing excess layers:

* Individual Risk Characteristics. Development of pricing and capacity (limits provided) for excess reinsurance layers is tied closely to the primary carrier's underwriting analysis of the account. Like the primary carrier, the reinsurer is going to base its capacity and pricing decisions largely on the construction, occupancy, protection and exposures of the risk.

* Loss Experience. Underwriters need to analyze loss experience not just of the individual risk but of the class of business. A dynamite manufacturer, for example, may have a loss-free past, but is always just a spark away from catastrophic loss. Thus, the issue of "frequency vs. severity" is an important part of the process.

* Probable Maximum Loss. Determination of PML will be a huge consideration in capacity and price of the account and reinsurance layers.

While PML, Maximum Foreseeable Loss and Net Loss Expectancy are important figures, PML generally makes up the basis of an underwriter's decision. Insurers define PML differently, but broadly, it is the largest amount of value that a risk could be expected to lose under normal circumstances.

* Attachment Point. An account seeking excess reinsurance will generally want a reinsurer to provide a layer or layers of capacity in excess of its own capacity. The point at which the primary carrier's financial interest stops and is ceded to the reinsurer is the "attachment point." This is analyzed by the reinsurer and is compared to the PML.

Generally, reinsurers expect primary carriers to retain at least 10% of the account values. That gives the primary carriers "some skin in the game"--a significant vested interest in quality and performance of the account.

* Distribution Scales. The most interesting part of excess pricing may be use of premium distribution scales. These are used to appropriate the premium to different layers of the total values at risk. Understanding the uses and logic behind the scales is essential to understanding pricing of layered accounts.

For example, with a 10-story office building worth $20 million, a primary carrier may be willing to accept $10 million, then cede the rest to a reinsurer. The premium charged for this property is $50,000. Logic dictates there's a greater likelihood of a loss in the first $10 million of coverage than having a loss over $10 million. Application of rating scales takes this into consideration and allots the $50,000 of total premium across the entire $20 million.

The Lloyd's Scale, widely available and relatively easy to use, is the best known of reinsurance scales. While it's good for primary carriers to review the Lloyd's Scale for a general idea of the price they can expect for a layer, underwriters should know that most reinsurers don't use this. Instead, they have developed proprietary systems and have numerous scales at their disposals to take individual risk characteristics into consideration. For example, the Lloyd's Scale would work fairly well for the office building referenced earlier. A very large portion of premium would be appropriated to the primary $10 million layer.

But what if this involved a dynamite manufacturer, with the good chance that a small fire could damage its entire location? As such, a larger portion of premium would need to be dedicated to the excess layer.

* Costs of Capital. Even if all parties agree that a layer is unlikely to suffer a loss, a premium charge is still applied. The reinsurer's capital has value and providing that capital warrants that a premium be charged. This "cost of capital" is often related to the state of pricing in the marketplace: in a soft market, capital is easier to find and its price is cheaper than in a hard market where capacity is scarce.

Underwriting of excess layers is a complex process. Understanding the factors involved in the analysis, pricing and capacity of excess layers will enrich an underwriter's job and make him or her better equipped to place layered deals,

Michael P. Egan, a Best's Review columnist, is a property officer with Swiss Reinsurance Co., Philadelphia. He can be reached at [e-mail].