Would you please explain stacking and the example in then notes with respect to stacking and XL layers in the chapter on original loss curves? How does stacking work in general and how does it affect any existing XL treaty?
So in the example the cedant has written two layers 400k xs 100k and 1m xs 500k. These are both protected by a reinsurance contract of 500k xs 500k. If the cedants two layers stack (or add together so that they apply sequentially to the same claim) then effectively they can be considered as one layer which is 1m xs 400k xs 100k or equivalently 1.4m xs 100k. In this case a reinsurance contract of 500k xs 500k would cover the losses from 100+500 (600k) up to 100+500+500 (1.1m) If the layers do not stack then they would apply separately to each claim as they stand. As the reinsurance contract starts at 500k any losses to the 400k xs 100k layer would not be covered by the reinsurance contract. The reinsurance contract therefore only protects the 1m xs 500k layer and covers losses from 500+500 (1m) to 500+500+500 (1.5m).
It is hard to say whether stacking is good or bad to the reinsurance cost, noting that it distort the shape of first loss curves. In the case above, stacking is worse than no stacking. But if we change the structue of the reinsurance cover to 200k XS 200k, the option of stacking will be preferable for reinsurers.
