DEFINITION OF ‘CODED EXCESS’
A type of excess of loss reinsurance in which the reinsurer receives a portion of the premium for each risk that is adjusted to take into account the individual covered risk’s effect on the entire reinsurance contract. Coded excess, also referred to as coded excess of loss, has a more complex pricing structure than other forms of excess of loss insurance, but is considered to provide a more accurate pricing structure.
INVESTOPEDIA EXPLAINS ‘CODED EXCESS’
Excess of loss reinsurance protects the reinsurance company against the portion of loss in excess of a specified limit. The premium is not proportional to the coverage limit, which allows the reinsurer to limit its financial responsibility to the proportion of the loss relative to the limit.
Reinsurance companies use coded excess insurance to control the original risk. The price of the reinsurance contract is dependent on the risks that the contract is designed to cover. The insurance company cannot change the composition of the risk portfolio in order to shift more risk to the reinsurer without also providing more premiums. The reinsurer will require that the risk composition is frozen once the reinsurance contract comes into effect, and will specify the types of risks that are (and are not) covered in the reinsurance treaty.
Coded excess is determined through a formula that adjusts the premiums the reinsurer is able to receive according to the risk that the reinsurer actually faces. This formula is outlined and agreed to in the reinsurance contract language. The premium that the reinsurance company receives is adjusted to remove the reinsurance commission. This allows the ceding company to reclaim a portion of the premium to cover management expenses. The formula also provides the reinsurer with more premiums if the ceding company changes the composition of the risk portfolio, since changes to the portfolio may increase the probability that the reinsurance company will be exposed to a loss.