Pricing a Reinstatement Premium Protection Cover (RPP)

It is quite simple to calculate the Reinstatement Premium resulting from a loss to an Excess of Loss contract. Therefore, it seems reasonable that we should be able to come up with a simple formula relating the price charged for the Excess of Loss contract to the price charged for the Reinstatement Premium Protection (RPP) cover.

I was in a meeting last week with two brokers who were trying to do just this. We had come up with an indicative price for an XoL layer and we were trying to use this to price the equivalent RPP cover. At the time I didn't have an easy way to do it, and when I did a quick Google search nothing came up. Upon further reflection, there are a couple of easy approximate methods we can use. 

Below I discuss three different methods which can be used to price an RPP cover, two of which do not require any stochastic modelling.

Let's quickly review a few definitions, feel free to skip this section if you just want the formula.

What is a Reinstatement Premium?

A majority of Excess of Loss contracts will have some form of reinstatement premium. This is a payment from the Insurer to the Reinsurer to reinstate the protection in the event some of the limit is eroded. In the London market, most contracts will have either $1$, $2$, or $3$ reinstatements and generally these will be payable at $100 \%$. From the point of view of the insurer, this additional payment comes at the worst possible time, the Reinsured is being asked to fork over another large premium to the Reinsurer just after having suffered a loss.

What is a Reinstatement Premium Protection (RPP)?

Reinsurers developed a product called a Reinstatement Premium Protection cover (RPP cover). This cover pays the Reinsured's Reinstatement Premium for them, giveing the insurer further indemnification in the event of a loss. Here's an example of how it works in practice:

Let's suppose we are considering a $5m$ xs $5m$ Excess of Loss contract, there is one reinstatement at $100 \%$ (written $1$ @ $100 \%$), and the Rate on Line is $25 \%$. The Rate on Line is just the Premium divided by the Limit. So the Premium can be found by multiplying the Limit and the RoL:

$$5m* 25 \% = 1.25m$$

So we see that the Insurer will have to pay the Reinsurer $1.25m$ at the start of the contract. Now let's suppose there is a loss of $7m$. The Insurer will recover $2m$ from the Resinsurer, but they will also have to make a payment  to cover the reinstatement premium of: $\frac {2m}  {5m} * (5m * 25 \% ) = 2m * 25 \% = 0.5m$ to reinstate the cover. So the Insurer will actually have to pay out $5.5m$. The RPP cover, if purchased by the insurer, would pay the additional $0.5m$ on behalf of the insurer, in exchange for a further upfront premium.

Now that we know how it works, how would we price the RPP cover?

Three methods for pricing an RPP cover

Method 1 - Full stochastic model

If we have priced the original Excess of Loss layer ourselves using a Monte Carlo model, then it should be relatively straight forward to price the RPP cover. We can just look at the expected Reinstatements, and apply a suitable loading for profit and expenses. This loading will probably be broadly in line with the loading that is applied to the expected losses to the Excess of Loss layer, but accounting for the fact that the writer of the RPP cover will not receive any form of Reinstatement for their Reinsurance.

What if we do not have a stochastic model set up to price the Excess of Loss layer? What if all we know is the price being charged for the Excess of Loss layer?

Method 2 - Simple formula

Here is a simple formula we can use which gives the price to charge for an RPP, based on just the deposit premium and the Rate on Line, full derivation below:

$$RPP = DP * ROL $$

When attempting to price the RPP last week, I did not have a stochastic model set up. We had come up with the pricing just based off the burning cost and a couple of 'commercial adjustments'. The brokers wanted to use this to come up with the price for the RPP cover. The two should be related, as they pay out dependant on the same underlying losses. So what can we say?

If we denote the Expected Losses to the layer by $EL$, then the Expected Reinstatement Premium should be:
$$EL * ROL $$
To see this is the case, I used the following reasoning; if we had losses in one year equal to the $EL$ (I'm talking about actual losses, not expected losses here), then the Reinstatement Premium for that year would be the proportion of the layer which had been exhausted $\frac {EL}  {Limit} $ multiplied by the Deposit Premium $Limit * ROL$ i.e.:

$$ RPP = \frac{EL}  {Limit} * Limit * ROL  = EL * ROL$$

Great! So we have our formula right? The issue now is that we don't know what the $EL$ is. We do however know the $ROL$, does this help?

If we let $DP$ denote the deposit premium, which is the amount we initially pay for the Excess of Loss layer and we assume that we are dealing with a working layer, then we can assume that:

$$DP = EL * (1 + \text{ Profit and Expense Loading } ) $$

Plugging this into our formula above, we can then conclude that the expected Reinstatement Premiums will be:

$$\frac {DP} { \text{ Profit and Expense Loading } } * ROL $$

In order to turn this into a price (which we will denote $RPP$) rather than an expected loss, we then need to load our formula for profit and expenses i.e.

$$RPP = \frac {DP} {\text{ Profit and Expense Loading }} * ROL * ( \text{ Profit and Expense Loading } ) $$

Which with cancellation gives us:

$$RPP = DP * ROL $$

Which is our first very simple formula for the price that should be charged for an RPP. Was there anything we missed out though in our analysis? 
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Method 3 - A more complicated formula:

There is one subtlety we glossed over in order to get our simple formula. The writer of the Excess of Loss layer will also receive the Reinstatement Premiums during the course of the contract. The writer of the RPP cover on the other hand, will not receive any reinstatement premiums (or anything equivalent to a reinstatement premium). Therefore, when comparing the Premium charged for an Excess of Loss layer against the Premium charged for the equivalent RPP layer, we should actually consider the total expected Premium for the Excess of Loss Layer rather than just the Deposit Premium.

What will the additional premium be? We already have a formula for the expected Reinstatement premium:

$$EL * ROL $$

Therefore the total expected premium for the Excess of Loss Layer is the Deposit Premium plus the additional Premium:

$$ DP + EL * ROL $$

This total expected premium is charged in exchange for an expected loss of $EL$.

So at this point we know the Total Expected Premium for the Excess of Loss contract, and we can relate the expected loss to the Excess of Loss layer to the Expected Loss to the RPP contract. 

i.e. For an expected loss to the RPP of $EL * ROL$, we would actually expect an equivalent premium for the RPP to be:

$$ RPP =  (DP + EL * ROL) * ROL $$

This formula is already loaded for Profit and Expenses, as it is based on the total premium charged for the Excess of Loss contract. It does however still contain the $EL$ as one of its terms which we do not know.

We have two choices at this point. We can either come up with an assumption for the profit and expense loading (which in this hard market might be as little as only be $5 \% - 10 \%$ ). And then replace $EL$ with a scaled down $DP$:

$$RPP =  \frac{DP} {1.075} * ( 1 + ROL) * ROL $$

Or we could simply replace the $EL$ with the $DP$, which is partially justified by the fact that the $EL$ is only used to multiply the $ROL$, and will therefore have a relatively small impact on the result. Giving us the following formula:

$$RPP =  DP ( 1 + ROL) * ROL $$

Which of the three methods is the best?

The full stochastic model is always going to be the most accurate in my opinion. If we do not have access to one though, then out of the two formulas, the more complicated formula we derived should be more accurate (by which I mean more actuarially correct). If I was doing this in practice, I would probably calculate both, to generate some sort of range, but tend towards the second formula.

That being said, when I compared the prices that the Brokers had come up with, which is based on what they thought they could actually place in the market, against my formulas, I found that the simple version of the formula was actually closer to the Broker's estimate of how much these contacts could be placed for in the market. Since the simple formula always comes out with a lower price than the more complicated formula, this suggests that there is a tendency for RPPs to be under-priced in the market.

This systematic under-pricing may be driven by commercial considerations rather than faulty reasoning on the part of market participants. According to the Broker I was discussing these contracts with, a common reason for placing an RPP is to give a Reinsurer who does not currently have a line on the underlying Excess of Loss layer, but who would like to start writing it, a chance to have an involvement in the same risk, without diminishing the signed lines for the existing markets. So let's say that Reinsurer A writes $100 \%$ of the Excess of Loss contract, and Reinsurer B would like to take a line on the contract. The only way to give them a line on the Excess of Loss contract is to reduce the line that Reinsurer A has. The insurer may not wish to do this though if Reinsurer A is keen to maintain their line. So the Insurer may allow Reinsurer B to write the RPP cover instead, and leave Reinsurer A with $100 \%$ of the Excess of Loss contract. This commercial factor may be one of the reasons that traditionally writers of an RPP would be inclined to give favourable terms relative to the Excess of Loss layer so as to encourage the insurer to allow them on to the main programme and to encourage them to allow them to wrte the RPP cover at all.

Moral Hazard

​One point that is quite interesting to note about how these deals are structured is that RPP covers can have quite a significant moral hazard effect on the Insurer. The existence of Reinstatement Premiums is at least partially a mechanism to prevent moral hazard on the part of the Insurer. To see why this is the case, let's go back to our example of the $5m$ xs $5m$ layer. An insurer who purchases this layer is now exposed to the first $5m$ of any loss. But they are indemnified for the portion of the loss above $5m$, up to a limit of $5m$. If the insurer is presented with two risks which are seeking insurance - one with a total sum insured of $10m$, and another with a total sum insured of $6m$, the net retained exposure is the same for both risks from the point of view of the insurer. By including a reinstatement premium as part of the Excess of Loss layer, an therefore ensuring that the insurer has to make a payment any time a loss ceded to the layer, the reinsurer is ensuring that the insurer keeps their financial incentive to not have losses in this range. 

By purchasing an RPP cover, the insurer is removing their financial interest in losses which are ceded to the layer. There is an interesting conflict of interest in that the RPP cover will almost always be written by a different reinsurer to the Excess of Loss layer. The Reinsurer that is writing the RPP cover is therefore increasing the moral hazard risk whichever Reinsurer has written the Excess of Loss layer. Which will almost always be business written by one of the Reinsurer's competitors! 

Working Layers and unlimited Reinstatements

Another point to note is that this pricing analysis makes a couple of implicit assumptions. The first is that there is a sensible relationship between the expected loss to the layer and the premium charged for the layer. This will normally only be the case for 'working layers'. These are layers to which a reasonable amount of loss activity is expected. If we are dealing with clash or other higher layers, then the pricing of these layers will be more heavily driven by considerations beyond the expected loss to the layer. These might be capital considerations on the part of the Reinsurer, commercial considerations such as 

Another implicit assumption in this analysis is that the reinstatements offered are unlimited,. If this is not the case, then the statement that the expected reinstatement is $EL * ROL$ no longer holds. If we have limited reinstatements (which is the case in practice most of the time) then we would expect the expected reinstatement to be less than or equal to this.
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