# Understanding Excess of Loss Reinsurance: Definition, Features, and Benefits

> **Definition**
>
> Excess of loss reinsurance is a type of reinsurance where the reinsurer compensates the ceding insurance company for losses above a predetermined limit.

## What Is Excess of Loss Reinsurance?

Excess of loss reinsurance is a type of non-proportional reinsurance in which the reinsurer indemnifies–or compensates–the [ceding company](https://www.investopedia.com/terms/c/ceding-company.asp) for losses that exceed a specified limit. A reinsurer is a company that provides financial protection to insurance companies; a ceding company is an insurance company that transfers the insurance portfolio to a reinsurer.

Excess of loss reinsurance helps provide financial protection and stability by covering significant losses beyond the insurer's retention limit, allowing the ceding company to underwrite a larger volume of risks.

Depending on the language of the contract, it can apply to either all loss events during the policy period or losses in aggregate. Treaties might use loss bands that decrease with each claim. Reinsurers and ceding companies use cost calculations like the [burning-cost ratio](https://www.investopedia.com/terms/b/burning-cost-ratio.asp) to set prices.

### Key Takeaways

*   Excess of loss reinsurance protects a ceding company from significant losses above a specified threshold.
*   This non-proportional reinsurance involves the reinsurer covering losses exceeding the agreed limit.
*   Contracts may require reinsurers to cover either all losses or a percentage of losses above the threshold.
*   Excess of loss reinsurance enhances a ceding insurer’s financial security and stability during significant loss events.
*   Reinsurance allows insurers to underwrite more policies without significantly raising costs, ensuring sufficient asset liquidity.

## How Excess of Loss Reinsurance Works and Its Benefits

[Treaty](https://www.investopedia.com/terms/t/treaty-reinsurance.asp) or [facultative reinsurance](https://www.investopedia.com/terms/f/facultative-reinsurance.asp) contracts often specify a limit in losses for which the reinsurer will be responsible. This limit is agreed to in the reinsurance contract; it protects the reinsurance company from dealing with [unlimited liability](https://www.investopedia.com/terms/u/unlimited-liability.asp). In this way, treaty and facultative reinsurance contracts are similar to a standard insurance contract, which provides coverage up to a specific amount. While this is beneficial to the reinsurer, it places the onus on the [insurance company](https://www.investopedia.com/articles/personal-finance/010715/worlds-top-10-insurance-companies.asp) to reduce losses.

Excess of loss reinsurance takes a different approach than treaty or facultative reinsurance. The reinsurance company is held responsible for the total amount of losses above a certain limit. For example, a [reinsurance contract](https://www.investopedia.com/terms/r/reinsurance.asp) with an excess of loss provision may indicate that the reinsurer is responsible for losses over $500,000. In this case, if aggregate losses amount to $600,000, then the reinsurer will be responsible for $100,000.

Excess of loss reinsurance can also work in a slightly different way. Rather than require the reinsurer to be responsible for all losses over a certain amount, the contract may instead indicate that the reinsurer is responsible for a percentage of losses over that threshold. This means that the ceding company and the reinsurer will share aggregate losses.

For example, a reinsurance contract with an excess of loss provision may indicate that the reinsurer is responsible for 50% of the losses over $500,000. In this case, if aggregate losses amount to $600,000, the reinsurer will be responsible for $50,000 and the ceding company will be responsible for $50,000.

An [excess of loss](https://www.investopedia.com/terms/e/excess-limits-premium.asp) reinsurance policy protects the [ceding](https://www.investopedia.com/terms/r/reinsurance-ceded.asp) insurer against large losses, providing more security for its equity and solvency. It can also provide more stability when unusual or major events occur.

Reinsurance lets insurers cover more risks without overly increasing costs, ensuring their solvency margins—the extra value of their assets over [liabilities](https://www.investopedia.com/terms/l/liability.asp)—remain intact. In fact, reinsurance makes substantial liquid assets available for insurers in case of exceptional losses.

## The Bottom Line

Excess of loss reinsurance is a non-proportional model where the reinsurer covers losses above a set limit, giving insurers vital financial protection and helping them manage risks effectively. It supports solvency, stabilizes finances during major events, and allows companies to underwrite larger volumes of risk.

Flexible agreements, like sharing losses above thresholds, let insurers tailor coverage to their needs, making it essential to understand contract limits and conditions for strong risk management and stability.