The Policy Structure 45

Can something like this exist in personal lines insurance? If it existed, it would work like
this (again, think of a car insurance policy): you (the customer) retain the first £200 of each
loss but only until the total amount you have retained in a year reaches £500: after that, the
insurer foots the whole bill of each loss. Insurers have no interest to remove any incentive
for policyholders to drive less recklessly for the rest of the year!
However, large corporate entities are different: they usually do not have one or two cars
but a whole fleet, and the presence of multiple claims is perfectly normal: having, say, 200
claims per year for a fleet of 1000 cars is not unusual. Furthermore, the risk (the driver) is
not the same as the buyer of insurance (the company), and therefore the moral hazard of
introducing an annual cap on the company’s retained liabilities is reduced.
Therefore, commercial insurers often offer their policyholders the possibility of cap-
ping the amount they retain in a given year (or period), so that if X1,X2,…Xn are the losses
incurred in a given year, the amount retained below the deductible becomes (ignoring for
now the limit L on each loss):

(
Total retained = min AAD , ∑ min(X , EEL)) (3.2)
j

And the total ceded is

 
Total ceded = ∑ X − min  AAD, ∑ min(X , EEL) (3.3)
j j

It should be noted that the AAD does not work in the same way in other contexts, such
as in reinsurance, where it stops you claiming the £AAD of claims that would otherwise
be recoverable given the EEL deductible, and is therefore often a source of confusion. The
AAD as is normally used in commercial lines insurance has a different effect: all amounts
below the EEL are retained and when these accumulate to the AAD, the insured is entitled
to recover the ground-up amount of each claim it incurs.

3.2.2.2.1 What Is the Purpose of the AAD, and How Should It Be Chosen?

The AAD provides further stability and security to the insured company by imposing a
cap on how much money it retains. To be effective, from the point of view of the insured, this
AAD should be something that is occasionally hit (otherwise, the AAD has no effect) but
it is not hit too often (otherwise the benefits of having an EEL are unclear – the same effect
could be obtained by simply capping the retention at the amount AAD – and all the vola-
tility is basically ceded to the insurer, at a cost which is likely to be high). The insured will
normally be happy if the AAD is hit 5% to 20% of the time.
From the point of view of the insurer, the tendency is instead to position the AAD at rather
high levels, so that it is hit as rarely as possible (e.g. ≤5% of the time): this is because the
insurer is exposed to the additional volatility arising from frequency effects, such as a
systemic increase of the number of claims. An insurer will often have guidelines for its
underwriters and an AAD breach may be frowned upon.

3.2.2.3 Each-and-Every-Loss Limit
Typically, policies will also have a limit for the compensation that the insured may receive
for a single loss and possibly on the aggregate.
46 Pricing in General Insurance

If there is an individual limit L but no AAD, there is a retained amount both below the
deductible and above the limit:

Total retained below the deductible = ∑ min(X , EEL)

j

Total retained above the limit = ∑ max(X − L − EEL, 0) (3.4)

j

Total ceded = ∑ min(L, max(X − EEL, 0))

j

If there is an AAD as well as an EEL and a limit L, the exact workings depend crucially
(although often not materially) on the exact wording of the contract. Specifically, it depends
on whether the limit works on a ‘drop-down’ or on a ‘stretch-down’ basis.
If the policy works on a drop-down basis, once the AAD is reached the insured still has
a cover of size L: that is, instead of being covered between EEL and L + EEL as was the case
with the first claims before the AAD was reached, it is now covered between 0 and L. The
‘layer’ of insurance has ‘dropped’ down to zero but still remains of the same size it had
originally (L).
If the policy works on a stretch-down basis, once the AAD is reached the insured has
a cover of size L + EEL: instead of being covered between EEL and L + EEL as in the first
few claims, it is now covered between 0 and L + EEL. The original layer has ‘stretched’ in
size – from L it has increased to L + EEL.
Whether a policy is drop-down or stretch-down depends very much on the initial pur-
pose of the insurance contract: for example, it depends on whether the policy is part of a
captive arrangement. We will see examples of this later on in the text, when we have the
tools to discuss it properly.
For now, let us just make sure that the mechanics of it are clear in both cases. Formulae
could perhaps be provided but they would stop being enlightening and would actually
start getting in the way, and it is better just to have a spreadsheet (or a programme code)
do the actual calculations. Figure 3.1 shows how these calculations can be performed in
practice in the case where the structure is ‘drop-down’. You can ignore the AL for the
moment.
Note that although the calculations in Figure 3.1 depend on the order in which losses
occur, the final result (the split between retained below the limit, ceded after AL, retained
above the limit) does not change if the order is changed. Figure 3.2 shows how the same
calculations in the ‘stretch-down’ case work. The difference, in this case, is very small.

3.2.2.3.1 What Is the Purpose of the Limit L, and How Should It Be Chosen?

As the name itself suggests, the function of the policy limit L is to limit the liability of
the insurer to a particular claim. Insurers are reluctant to write contracts with unlimited
liability because the absence of a clearly defined worst-case scenario makes it difficult to
determine, for instance, how much capital should be set aside for large claims and makes
buying reinsurance more challenging. Reinsurers, who deal with very large claims as a
matter of course, are also averse to unlimited liability for the same reason. The insurance
industry has often lobbied against the legal requirement for motor third party liability to
be sold with unlimited liability in such countries as the United Kingdom, France, Belgium
and Finland. Therefore, insurers will set a limit to their liability in the insurance contract
whenever they are legally allowed to do so.
The Policy Structure 47

Example of Retention/Cession Calculations in a Policy Year (Drop-Down Basis)

Insurance structure EEL 100,000
AAD 300,000
L 500,000
AL 10,000,000
Basis Drop-down

Loss 1 Loss 2 Loss 3 Loss 4 Loss 5 Loss 6 Loss 7 Total losses

Gross 1,150,000 61,000 19,000 73,000 1,457,000 299,000 1,208,000 4,267,000
Retained before AAD 100,000 61,000 19,000 – 100,000 100,000 100,000 553,000
Cumulative retained 100,000 161,000 180,000 253,000 353,000 453,000 553,000 553,000
Cumulative retained 100,000 161,000 180,000 253,000 300,000 300,000 300,000 300,000
after AAD
Retained after AAD 100,000 61,000 19,000 73,000 47,000 – – 300,000
Amount of cover 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000
Ceded before AL 500,000 – – – 500,000 299,000 500,000 1,799,000
Retained above limit 550,000 – – – 910,000 – 708,000 2,168,000

FIGURE 3.1
In the example above, we assume that there have been seven losses in the year under consideration, whose
ground-up values are in the row denoted as ‘Gross’. The ‘Retained before AAD’ row is calculated as min(EEL,
Gross). The total amount retained is calculated in the row ‘Cumulative Retained’ by adding the elements of the
row above that cumulatively. The total amount is then capped to AAD in the following row, ‘Cumulative after
AAD’. The ‘Retained after AAD’ row is calculated simply as the difference between two successive values of
the ‘Cumulative Retained after AAD’ row and gives the amount retained for a given loss after allowance has
been made for AAD. The row ‘Amount of Cover’ is, in the drop-down case, simply the limit (£500,000) – in the
stretch-down case, it will be slightly more complicated. The row ‘Ceded before AL’ is the amount ceded to the
insurer, capped by L (the limit). The symbol ‘AL’ means aggregate limit, which can be ignored here. The amount
retained above the limit is calculated as the gross amount minus the retained after AAD minus the ceded before
AL and is shown in the row ‘Retained above Limit’.

Example of Retention/Cession Calculations in a Policy Year (Stretch-Down Basis)

Insurance structure EEL 100,000
AAD 300,000
L 500,000
AL 10,000,000
Basis Stretch-down

Loss 1 Loss 2 Loss 3 Loss 4 Loss 5 Loss 6 Loss 7 Total losses

Gross 1,150,000 61,000 19,000 73,000 1,457,000 299,000 1,208,000 4,267,000
Retained before AAD 100,000 61,000 19,000 73,000 100,000 100,000 100,000 553,000
Cumulative retained 100,000 161,000 180,000 253,000 353,000 453,000 553,000 553,000
Cumulative retained 100,000 161,000 180,000 253,000 300,000 300,000 300,000 300,000
after AAD
Retained after AAD 100,000 61,000 19,000 73,000 47,000 – – 300,000
Amount of cover 500,000 500,000 500,000 500,000 553,000 600,000 600,000 600,000
Ceded before AL 500,000 – – – 553,000 299,000 600,000 1,952,000
Retained above limit 500,000 – – – 857,000 – 608,000 2,015,000

FIGURE 3.2
This example is the same as in Figure 3.1, but now the policy structure works on a stretch-down basis.
Everything works the same up to the row ‘Amount of Cover’: in the stretch-down case, however, we see that
when the AAD is exhausted, the cover is gradually increased up to EEL + L = £600,000. Specifically, when Loss 5
(£1,457,000) occurs, the first £47,000 is retained, at which point the annual aggregate cap is exhausted. The differ-
ence between the higher point of the cover (£600,000) and £47,000, which is £553,000, is ceded to the insurer, and
the rest is retained above the limit. For any subsequent loss, no amount is retained below the EEL deductible
and the first £600,000 goes straight to the insurer.