What is Second Event Retention
Second event retention is a strategy used to keep a ceding insurer in an excess of loss reinsurance treaty, in which payout levels are reduced after each subsequent occurrence. Second event retention, also known as drop down, works under the assumption that the ceding insurer will be less able to retain losses on its own as the number of claims increases. Second event rentention is most commonly used in catastrophe reinsurance.
BREAKING DOWN Second Event Retention
When insurance companies underwrite a new policy, they are creating a liability equal to the coverage limit stated in the contract. In exchange for indemnifying the insured for up to the coverage limit, the insurer receives a premium. The more policies that the insurer creates, the more risk that the insurer is exposed to. In order to reduce this risk, the insurer can enter into a reinsurance agreement with a reinsurance company. The reinsurer agrees to take on some of the insurer’s risk in exchange for some of the policy premiums.
An insurer is not required to cede the entire risk associated with a policy to a reinsurer, and can instead choose to retain some of the losses for itself. This reduces the cost of the reinsurance contract. Losses above what the insurer retains but below the policy limit are called the excess of loss, and this can be covered by excess-of-loss reinsurance. In the case of a reinsurance treaty that covers multiple occurrences, the insurer may choose to retain a smaller amount of losses with each subsequent occurrence. This means that the insurer’s retention decreases with each occurrence, while the reinsurer’s excess-of-loss liability increases.
Second Event Retention Example
For example, a property insurance company purchases catastrophe reinsurance. Because the insurer operates in a state prone to hurricanes the reinsurance agreement covers multiple occurrences. The insurer is responsible for $100 million of retained losses after the first hurricane, $95 million after the second, and $90 million after the third. This "drop down" in loss responsibility is called the second event cover.
Insurers often look to the reinsurance market to reduce their liabilities in the case of a catastrophe. These agreements are often structured into layers with different attachment points based off of loss retention. Each subsequent layer provides cascading excess of loss coverage over the preceding layer, so the fourth layer will only come into effect if the aggregate losses on the third layer are exhausted. This aggregate coverage is purchased for a single event, and insurers looking to have subsequent events covered will need to purchase a dedicated second event cover.