A reinsurance treaty is merely an agreement between two or more insurance companies whereby one (direct insurer) agrees to cede and the other or others (reinsurer) agree to accept reinsurance business as per provisions specified in the treaty.
More specifically, it is a pre-arranged agreement whereby the direct insurer cedes and the reinsurer(s) accepts cessions within a pre-determined limit.
The important feature here is that if cessions are made as per terms of the treaty, the reinsurer(s) cannot refuse to accept.
5 Types of Treaty Reinsurance are;
- Quota Share,
- Excess of Loss,
- Excess of Loss Ratio (Stop-Loss), and
Discussion, with examples, will now follow;
1. Quota Share Treaty Reinsurance
This type of treaty requires the direct insurer to cede a predetermined proportion of all its business accepted in a certain class to the reinsurer(s), and the reinsurer(s) also agrees to accept that proportion in return for a corresponding proportion of the premium.
Example 1: Quota Share; arrangement: Direct Insurer: 10% and All Reinsurers: 90%. Risk assumed: $1,000,000. Therefore, risk distribution will be as follows:
|Direct Insurer||10%||= $1,00,000|
|All Reinsurers||90%||= $9,00,000|
Example-2: Quota share arrangement: Same as before. Risk assumed $100,000 (same type of risk) Therefore, risk distribution will be:
|Direct Insurer||10%||= $10,000|
|All Reinsurers||90%||= $90,000|
It should be noticed by the students from the above two examples that for a similar type of risk the amount falling onto the shoulder of the direct insurer is varying simply because of the term of the treaty, even though he could safely retain more.
Maybe in the 2nd example, the direct company could retain the full amount of $100,000 thereby earning the whole of the premium. But the contract is debarring him from doing so as he must cede as per the predetermined percentage.
In spite of the above shortcomings, this type of arrangement is, however, particularly helpful for small offices or a new office or for offices who are starting a new type of business.
In the case of a loss, it will be borne by all in the same proportion.
2. Surplus Treaty Reinsurance
The important feature here is, this that the direct insurer agrees to reinsure only the surplus amount,
after its retention,
and the reinsurers agree to accept such cessions, usually up to a predetermined upper limit. Surplus treaties are usually arranged in lines, each fine being equal to the insurer’s retention.
This means that the insurer can automatically make a gross acceptance of the risk to the extent of his retention, plus, the amount of retention multiplied by the number of lines for which a treaty has been made.
Proposition: ABC Insurance Co. has received a proposal for fire insurance, from a textile mill for an amount of $1,00,00,000, The company’s retention for this class of business is $10,00,000, A 9-line surplus treaty exists. The arrangement will be as follows:
|ABC’s Retention||= $1,000,000|
|Treaty consumes (9×10 lac)||= $9,000,000|
Proposition: Same as Example 1, but the sum insured is $7,000,000. Arrangement will be:
|ABC’s Retention:||= $1,000,000|
|Treaty receives:||= $6,000,000|
It will be observed by the students that the treaty receives the- balance only after ’ceding Co’s retention and even though the treaty has got higher capacity, it is under placed because the sum-insured itself is lower than capacity and therefore they get the full balance of the sum insured.
Proposition: Same as in Example – 1, but the sum insured is $15,000,000 and a treaty upper limit exists for $8,000,000. The arrangement will be:
|Treaty consumes: (upper limit applies)||$8,000,000|
The students must realize here that the principle of reinsurance is being violated by such an attempt.
On the one hand, the excess retention of $500,000 will create an additional charge on the company’s fund for which there is no provision and which attempt is bound to disturb the company’s financial stability and profitability,
and on the other is sure to create an adverse impact on the reinsurer’s interest, in addition to the creation of a mistrust which is undesirable in this trusted profession.
Because of the merits involved, this is the most accepted form of reinsurance nowadays.
Whilst all the advantages of facultative and quota share system are there, the disadvantages of these two types are missing. Important advantages of the surplus treaty are
- The cover is automatic as opposed to the facultative system.
- It is less expensive in comparison to facultative and little procedural formalities are involved.
- Unlike the quota system, the ceding company can retain whatever it likes and the balance only is ceded. Unnecessary cession of business and premium is not envisaged.
- This method is of particular advantage to established companies who are growing concerns and who have scope for gradually increasing their retention with the increase in financial strength.
Demerits are very little and some of the minor ones are:
- For big liability insurances or protection against losses of catastrophe nature, other methods like Excess of Loss or Stop Loss arrangements are better suited.
- Reinsurers cannot usually apply underwriting judgment for each case, even though they might have entries into ceding the company’s account at periodical intervals.
- This method is not suitable for new insurance companies.
3. Excess of Loss Treaty Reinsurance
The approach of the reinsurance arrangement is quite different here from those methods already discussed.
Under this system, unlike facultative, quota or surplus, the sum insured does not form any basis and it is not expressed in terms of proportion or percentage of the sum insured.
Here, the insurer first decides as to how much amount of loss he can bear on each loss under a particular class of business.
The arrangement is such that if a loss exceeds this predetermined amount then only reinsurers will bear the balance amount of loss. Nothing is payable by the reinsurers if the amount of loss falls below this selected amount.
There may usually be an upper limit of liability of the reinsurers beyond which they will not pay.
Proposition: Against all public liability insurances, the insurer decides to bear a loss of up to $100,000 in respect of every loss. The reinsurers agree to bear any balance amount beyond $100,000. The loss is $200,000. There is an upper limit of $80,000.
The recovery under the reinsurance arrangement will be as follows:
|Loss: $200,000. Upper limit:||$ 80,000|
|Insurer bears:||$ 1,00,000|
|Reinsurer bears:||$ 80,000|
|Insurer again bears the|
|balance because of the upper limit:||$ 20,000|
|Therefore, Insurer bears||$ 1,20,000|
|Reinsurer bears||$ 80,000|
You should realize that if there would have been no upper limit, reinsurers would have borne $100,000.
This type of reinsurance arrangement is particularly helpful in cases of big liability insurances and for obtaining protection against catastrophe losses.
4. Excess of Loss Ratio Treaty Reinsurance
This type of arrangement is also known as STOP LOSS reinsurance and is a bit different from the Excess of Loss arrangement, even though both base on loss rather than sum-insured.
Here, a relationship is usually drawn in between the gross premium and the gross claim over a year in a particular class of business. The ceding company decides a gross loss ratio up to which it can sustain.
The arrangement with the reinsurers is such that if at the year-end it is found that the total of all losses within the class has exceeded the predetermined loss ratio then the reinsurers will pay the balance loss to keep the loss ratio of the ceding company within the ‘predetermined ratio. The treaty may contain an upper limit also.
Proposition: Company ABC has arranged an Excess of Loss Ratio Treaty with reinsurers whereby it will bear losses up to an amount not exceeding 70% of the gross premium of the class.
The reinsurers have agreed to bear any balance so that the ceding company’s gross loss ratio is maintained at 70%, but not exceeding say 90% of the balance.
Ceding company’s premium income is $10,000,000 and the total loss over the year is $8,000,000.
The implication of loss distribution will be as follows Loss $8,000,000.
This is 80% of the gross premium and therefore, reinsurers come into the picture to keep this ‘loss ratio’ down to predetermined 70%. Therefore;
|Ceding Co. bears (70% of premium)||=$7,000,000|
|Reinsurer pays 90% of $1,000,000||=$900,000|
|(which is the balance of loss)|
|Ceding Co. again bears balance||=$100,000|
|Ceding Co. bears:||$7,100,000|
|Reinsurers pay :||$900,000|
The students should realize that had there been no upper limit the full balance of $1,000,000 would have been paid by the reinsurers and the predetermined loss ratio of the ceding company would have been maintained.
In this case, because of the upper limit, the predetermined loss ratio has been partly disturbed.
This type of reinsurance is widely used for liability insurances and catastrophe losses.
5. Pools Treaty Reinsurance
Pools are treaties, either quota share or surplus, in the sense that under these arrangements various member countries or member companies join their hands together beforehand for sharing each other’s premium as well as a claim.
These pools usually operate in respect of especially hazardous classes of business or where the market as a whole is weak to absorb the risk.
In such circumstances, such pools providing mutual support become very useful. Examples of risks may be crop insurance, workmen’s compensation insurance, etc.