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Reinsurance Nuts & Bolts: What is an Aggregate Extraction Clause?

August 10th, 2010 Accumulation of Loss, Aggregate Cover, Nuts & Bolts, Nuts & Bolts: Reinsurance, Reinsurance Allocation, Reinsurance Claims Comments Off on Reinsurance Nuts & Bolts: What is an Aggregate Extraction Clause? By Philip J. Loree Jr.

A.   Introduction

Over a year ago we ran a Reinsurance Nuts & Bolts feature entitled “Aggregate Extension Clauses”  (here).  To our considerable surprise, that article was, and remains, one of our more popular ones. 

At the close of the article we said (tongue in cheek):  “If you, the reader, have gotten this far, then perhaps you would like to delve into a discussion of ‘Aggregate Extraction Clauses.’  But these clauses – which conjure up some of the more frightening scenes from Marathon Man (1976) – are better left for another day.  .  .  . ”  Brace yourselves, for we fear that day has arrived.  .  .  .        

B.   What is an Aggregate Extraction Clause? 

To put aggregate extraction clauses in context a very brief review of aggregate cover and aggregate extension clauses is in order.  As discussed in our aggregate extension clause feature (here), policies covering on an aggregate basis are designed to insure principally against the risk that the frequency of relatively small (i.e., low severity) losses will exceed an expected level during a given period.  That’s why products liability risks are frequently written on an aggregate basis – i.e., to protect against the high-frequency, low-severity “Coca-Cola-type”  losses discussed by the English Court of Appeal in Yasuda Fire & Marine Co. of Europe Ltd v. Lloyd’s Underwriting Syndicates No. 209, 356 & Ors., [1998] Lloyd’s Rep. LR. 343 (C.A.). 

The existence and amount of aggregate coverage is determined by aggregating together all losses occurring within a specified period, irrespective of their severity.  That aggregate amount is subject to an aggregate deductible and frequently an aggregate limit.   

Reinsuring aggregate cover on an excess of loss basis presents problems because the amount of each loss or occurrence is generally not high enough to exceed the retention of the excess of loss treaty.  Over a period, however, the accumulated loss covered by the policy might well exceed the retention of the excess of loss treaty were it deemed to arise from a single occurrence.   

We explained in our prior article (here) that the aggregate extension clause effectively extends the aggregate cover of the underlying policy into the excess of loss treaty.   Instead of subjecting each individual loss or occurrence to a separate retention and limit, it allows the aggregation of losses or occurrences when the original policy is written on an aggregate basis.   

The aggregate extraction clause deals with the special problems that may arise when losses covered on an aggregate basis arise out of a single occurrence that has also caused loss under one or more policies that were not written on an aggregate basis.  If – as is sometimes the case — the loss arising out of a single occurrence is of relatively high severity, then it is not the type of loss that either the aggregate policy or the aggregate extension clause was principally designed to cover.   And when the relatively severe loss is lumped into the aggregate cover provided by the reinsurance contract, it eats up capacity that was designed principally to accommodate high frequency, low severity losses. 

At the same time, the cedent is deprived of the ability to accumulate the single-occurrence aggregate-loss with non-aggregate losses on other reinsured policies arising out of the same occurrence.   Thus, while the cedent may get the benefit of clash cover protection on single-occurrence, non-aggregate losses arising out of multiple, non-aggregate policies, it loses that benefit in situations where a portion of the loss arising out of the occurrence is covered on an aggregate basis.   (An excess of loss contract provides clash cover when a single occurrence under the treaty is subject to a single retention and limit, irrespective of the number of original policies that respond to the occurrence.  This type of cover reinsures against the accumulation of net retained liability under multiple, original policies arising from the same occurrence.)   

The aggregate extraction clause addresses both of these problems.   It allows the cedent to extract from aggregate reinsurance coverage a single-occurrence-based loss on policies written on an aggregate basis and combine it with other losses on non-aggregate policies that arise out of the same occurrence.  Brokers and Reinsurance Markets Association (“BRMA”) clause 4A is an example of an aggregate extraction clause: 

As regards liability incurred by the Company for losses on a policy or policies covering on an aggregate basis, the Company shall be permitted to extract from such aggregate policy or policies the amount of loss sustained by it arising from one loss occurrence in order that such loss can be added to the Company’s losses from the same occurrence on [an]other policy or policies, if any.

For the purposes of this Article, the amount of loss from one occurrence on an aggregate policy shall be deemed to be that percentage of the aggregate loss to the Company that the total loss from the particular occurrence bears to the total aggregate losses to the insured or company on the business protected by such aggregate policy. 

To operate the clause requires the following: 

1.  There must be liability incurred by the Company for losses under a policy covering on an aggregate basis;  

2.  Some of that loss (in 1., above) must arise out of a single occurrence for the purposes of the reinsurance contract;

3.  The cedent must have also incurred liability for loss or losses under one or more other original policies that do not provide cover on an aggregate basis; and

4.  Those losses (referred to in 3., above) must arise out of the same occurrence as the aggregate loss referred to in 2., above.  

When all these requirements are met, the cedent may remove from aggregate coverage the loss referred to in 2., above, and combine it with the losses referred to in 3., above. 

Typically, the loss extracted from aggregate reinsurance coverage will be of relatively high severity compared to the other losses falling under the reinsurance contract’s aggregate coverage.   Otherwise there would likely be little reason for the cedent to exercise the aggregate extraction option. 

The second paragraph of the clause provides a formula for determining the amount of aggregate loss deemed to arise out of the single occurrence.  To calculate that amount, our hypothetical ceded-claims person would divide the total amount of loss arising from the occurrence under all reinsured policies by the “total aggregate losses to the insured or company on the business protected by such aggregate policy,” multiply the result by 100, and multiply the resulting percentage figure by the total amount of aggregate loss on the aggregate policy.  The product would equal the amount of loss under that aggregate policy deemed to arise out of the single occurrence and therefore subject to aggregate extraction.  

And that, in a nutshell, is what an aggregate extraction clause is and does.  .  .  .

         

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