How does excess of loss reinsurance typically function?

Excess of loss reinsurance operates by providing coverage to the ceding company (the insurance company that purchases the reinsurance) for losses that exceed a predetermined threshold known as the retention limit. This structure is designed to protect the ceding company from catastrophic losses or a series of large claims that could significantly impact its financial stability.

In this arrangement, if the losses incurred by the ceding company exceed the specified retention limit, the excess of loss reinsurer steps in and indemnifies the ceding company for the amount of those losses that go beyond the threshold. This allows the ceding company to manage its risk exposure more effectively while also maintaining its capacity to underwrite additional policies without overextending itself financially.

The other options do not accurately describe how excess of loss reinsurance functions. For example, a solution that pays based on a percentage of total losses does not reflect the specific mechanism of excess of loss, which deals solely with losses beyond a set amount. Similarly, guaranteeing a fixed payout to policyholders is more characteristic of traditional reinsurance structures rather than excess of loss reinsurance, which is contingent upon the losses exceeding the retention limit. Finally, covering losses only for specific risks would not encompass the fundamental nature of excess of loss reinsurance, which