Second Surplus

What Is a Second Surplus?

A second surplus describes a reinsurance treaty that provides coverage above that of a first surplus reinsurance treaty. Insurers enter into surplus reinsurance treaties in order to transfer some of their own risk or liability to another party.

How a Second Surplus Works

Second surplus reinsurance, also known as follow-on reinsurance, applies to any risks that the ceding insurer does not keep for its own account and that exceed the capacity of the first surplus treaty. The ceding insurer often requires a second surplus treaty if it cannot secure a reinsurance treaty that covers enough risk to ensure its own solvency.

When an insurer enters into a reinsurance treaty, it retains liabilities up to a specific amount, which is called a line. Any remaining liability goes to the reinsurer, which participates only in risks any above what the insurer retains. The total amount of risk that the reinsurance treaty covers, called the capacity, is typically expressed in terms of a multiple of the insurer’s lines.

The reinsurer does not participate in all risks assumed by the ceding company. Instead, it only assumes the risks above what the insurer retains, making this type of reinsurance different than quota share reinsurance.

By ceding some of its own risk to a reinsurer, the insurance company helps ensure its own solvency because it carries less risk of having to make large payouts to policyholders. These surplus treaties typically have enough capacity to cover multiple lines, but in some cases, they cannot cover the entire amount needed by the ceding company. In this event, the ceding insurer either has to cover the remaining amount itself or enter into a second reinsurance treaty. This second reinsurance treaty is referred to as the second surplus treaty.

Example of a Second Surplus

Let’s say a life insurance company is looking to reduce its liability through a reinsurance treaty. It has $20 million in obligations from the multiple policies that it has underwritten but only wants to retain $2 million of that risk. The surplus is the difference between the total liability and the retained risk, or $18 million.

Each line of retention is set at $1 million. The life insurance company enters into a first surplus reinsurance treaty with a reinsurer. The reinsurer takes on the risk of eight lines, covering $8 million. However, with this $8 million in reinsurance and the $2 million retained, the ceding company still must find a reinsurer for its remaining $10 million of risk.

The ceding company then seeks out another reinsurer for a second surplus reinsurance treaty to cover the remaining $10 million of risk. Alternately, it could find a reinsurer to cover only part of that $10 million, and another third treaty to cover the remaining amount to be covered.