DEFINITION of ‘Extraction Factor’
The portion of an insurance company’s subject premium that is deducted from what is owed to a reinsurance company under the terms of a reinsurance treaty. The extraction factor is typically calculated as a percentage, and is used to adjust the amount owed by the reinsured party based on the policies that are and are not covered under the reinsurance treaty.
INVESTOPEDIA EXPLAINS ‘Extraction Factor’
When an insurance company uses reinsurance as a risk management tool, it is agreeing to cede some of its risk exposure to a reinsurance company. Depending on the type of arrangement that it has with the reinsurance company, it can either cede all policies that it underwrites (facultative reinsurance) or can negotiate with the reinsurer over specific policies. The reinsurer receives a fee or a portion of the premiums that the insurance company underwrites or earns in exchange for taking on the risks associated with the policies.
The subject premium represents the portion of a reinsured company’s premium – the company ceding premiums to a reinsurer in exchange for reinsurance coverage – that the reinsurer collects under the terms of the reinsurance treaty. The amount that the reinsurer receives is equal to the subject premium multiplied by the reinsurance premium rate. The subject premium may use the value of underwritten premiums or earned premiums.
In some cases the subject premium has to be adjusted to account for policies that are not covered under the reinsurance contract. This adjustment is made using the extraction factor. The extraction factor deducts premiums for risks that are not covered under the agreement. For example, a reinsurance arrangement in which the ceding company shifts liability claims to the reinsurer may not cover particular liabilities, such as third-party liabilities. The extraction factor would remove the premiums associated with third-party liabilities, and would thus reduce the premiums owed to the reinsurer.