Understanding Treaty Reinsurance

Treaty reinsurance allows an insurance company, known as the ceding company, to transfer a portfolio of risks to a reinsurer, thus achieving greater financial stability and capacity to underwrite new policies. The essence of treaty reinsurance lies in its broad, automatic coverage of classes of business, rather than reinsurance of individual policies on a one-off basis. This ensures a systematic and efficient transfer of risk.

The ceding company's main role in a treaty reinsurance agreement is to identify and delineate the classes of business it seeks to reinsure and manage the claims efficiently. By doing so, the company aims to manage its overall risk exposure, maintain solvency, and optimize its capital efficiency. The ceding company must carefully select its reinsurer partner based on financial strength, reputation, and the reinsurer's expertise in handling specific types of risks.

Upon entering into a treaty reinsurance agreement, the reinsurer commits to accepting risks that fall within the agreed-upon classes of business. This requires the reinsurer to understand these risk categories and manage them effectively. The reinsurer's role is crucial in providing necessary reinsurance capacity to the ceding company, enabling it to pursue growth strategies or enter new markets. Ceding companies will take credit for reinsurance on their annual statements, which provides capital enhancements to the ceding company's balance sheet.

Treaty reinsurance agreements are structured to provide mutual benefits to both parties. The ceding company achieves risk diversification and capital relief, while the reinsurer receives premium income and opportunities for profitable engagement with a range of insurance risks.

Types of Treaty Reinsurance

Treaty reinsurance is categorized into two primary types based on the method of transferring risk and the financial arrangement between the ceding company and the reinsurer. These are proportional treaty reinsurance and nonproportional treaty reinsurance.

Proportional Treaty Reinsurance

In proportional treaty reinsurance, also known as quota share reinsurance, the ceding company and the reinsurer agree to share premiums and losses in a predetermined ratio. This arrangement allows the ceding company to expand its underwriting capacity by sharing a portion of the risk and the associated premium income with the reinsurer. The reinsurer, in return, pays a cedingcommission to the ceding company to cover acquisition costs. Proportional treaties are favored for their simplicity and the direct alignment of interests between the ceding company and the reinsurer. Transactions on a proportional treaty are primarily an accounting function, as premiums and losses are netted out on a monthly or quarterly basis and reported on what is called a bordereaux.

Nonproportional Treaty Reinsurance

Nonproportional treaty reinsurance, which includes forms such as excess-of-loss and stop-loss agreements, provides coverage to the ceding company for losses exceeding a specified retention or attachment point. This arrangement is particularly valuable for managing the impact of large or catastrophic losses. A common form of reinsurance using this formulation is catastrophe reinsurance, which protects the ceding company's excess loss exposure. The ceding company retains a portion of the risk up to the agreed limit, beyond which the reinsurer assumes responsibility for the excess losses up to the cap on the reinsurance amount.

Excess-of-loss treaties are often layered in a way similar to excess insurance to form a tower of reinsurance protection. Nonproportional treaties may sit alongside or on top of proportional treaties to round out a ceding company's reinsurance program.

The choice between proportional and nonproportional treaty reinsurance depends on the ceding company's risk appetite, financial objectives, and the specific characteristics of the risks being insured, and well-structured reinsurance programs may incorporate elements of both types.

FAQs

Q: What differentiates treaty reinsurance from facultative reinsurance?

A: Treaty reinsurance involves a pre-agreed arrangement where the reinsurer agrees to accept all risks of a specified class or classes from the ceding company. In contrast, facultative reinsurance is negotiated on a risk-by-risk basis, where each risk is individually underwritten and accepted. Treaty reinsurance provides automatic coverage for the ceding company's portfolio, while facultative reinsurance offers tailored solutions for specific risks.

Q: How are treaty reinsurance rates determined?

A: The rates for treaty reinsurance are determined based on a variety of factors, including the type and volume of risks being transferred, historical loss data, the financial stability of the ceding company, and prevailing market conditions. For proportional treaties, the premium rate is often a percentage of the ceding company's premium for the reinsured risks. For nonproportional treaties, the premium is calculated considering the likelihood and potential severity of losses exceeding the retention level.

Q: What are the key elements of a reinsurance treaty agreement?

A: A reinsurance treaty agreement typically includes the following key elements: the scope of coverage specifying the classes of business and types of risks covered; the period of coverage; terms of premium payment and loss sharing; provisions for loss reporting and claims handling; audit and inspection rights; provisions for treaty adjustments or termination; an insolvency clause; and clauses detailing obligations in the event of disputes. These agreements also outline any exclusions, conditions for reinstatement of coverage, and any special arrangements, such as profit-sharing or commissions.

Q: How are losses reported?

A: Generally, losses are reported to a quota share reinsurer on a statement of account or "bordereau" basis where the details of individual losses are not disclosed. Excess-of-loss treaties generally require individual loss reporting and often notice of potential losses when the ceding insurer's loss reserves exceed a threshold amount.