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Treaty Reinsurance

Updated on May 11, 2024
Article byPriya Choubey
Edited byPriya Choubey
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Treaty Reinsurance?

Treaty Reinsurance is the process whereby the insurer shields the complete portfolio of a ceding company from the overall risk involved in a particular insurance class. The insurance company that transfers the insurance risk is termed a cedent, whereas the one that purchases the insurance is the reinsurer.

Treaty Reinsurance

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It is a contract that ensures stability and risk-sharing among insurance providers. It protects the cedent from unforeseen events and mitigates the risk associated with the issuance of a specific class of insurance policies. The reinsurer gets a premium for purchasing the insurance and underlying risks.

Key Takeaways

  • Treaty reinsurance involves the insurer securing the ceding company from a potential insurance risk by purchasing its complete books of a particular class of policies.
  • It can be categorized into three main types: surplus, quota share, and excess of loss treaties.
  • This arrangement facilitates risk-sharing and stability in the financial or insurance sector. It further helps the ceding companies to maintain sufficient liquidity and solvency position.
  • In contrast, facultative reinsurance shields the cedent from individual risks or specific risk packages, offering protection on a case-by-case basis.

Treaty Reinsurance Explained

Treaty reinsurance is a risk-sharing mechanism in the insurance sector. It involves one insurer covering the entire books of a specific insurance class of another insurer. This ensures stability and risk-sharing in the industry. It can be divided into three distinct types:

  1. Surplus treaty reinsurance involves the ceding company keeping a part of the risk while transferring the additional risk to the insurer.
  2. In a quota share treaty, risk-sharing occurs at a predetermined fixed rate of premium and loss pertaining to the covered risks.
  3. Excess of loss treaty protects the cedent’s loss to an extent beyond the attachment point.

In this arrangement, the reinsurer executes a contract with the ceding insurer to purchase their complete books of specific policies after analyzing the overall risk. The treaty includes all the relevant terms and conditions as agreed upon between the parties. Moreover, it mentions the covered risk profile, the liability limitations, and the reinsurer’s premium.

Reinsurance premium is a percentage of the cedent’s total written premiums of the underlying risk cover. Also, the treaty states the maximum loss the insurer would bear, whether on an aggregate or per-event basis, in case of an unforeseen event. Indeed, the reinsurance treaty is a long-term partnership built on cordial relations between both parties.

Examples 

Insurance providers seek different reinsurance models to mitigate risks under varying circumstances. Let us understand the use of treaty reinsurance in the financial sector through the following examples:

Example #1

Suppose ABC Insurance Ltd. offers health plans that provide coverage for coronavirus treatment along with 28 other diseases and medical conditions. The company has sold policies worth $43 million. ABC Insurance Ltd. entered into a treaty reinsurance contract with XYZ Insurance Co. to transfer the risk involved with its health insurance policies, assuming that the COVID-19 cases would surge in the future.

Example #2

The Direct Line Group, a leading UK insurer for motor and home coverage, recently concluded a strategic reinsurance deal effective from January 1, 2023. This is facilitated through its key underwriter, UK Insurance Limited. This agreement brokered through its key underwriter, UK Insurance Limited, involves a 3-year structured 10% quota share treaty.

The contract was made after the company opted to forego its 2022 final dividend. This decision was prompted by unexpectedly high weather-related claims, totaling £140 million for the year, surpassing the initial estimate of £73 million.

Moreover, the recent legal developments indicate a potential increase in claims, particularly in the motor insurance sector, which is significant for Direct Lines. Consequently, the company opted to implement additional reinsurance measures to mitigate future uncertainties.

The new contracts are expected to improve the year-end 2022 solvency capital ratio by approximately 6%. Gallagher Re provides advisory support during the negotiation process, emphasizing the value of strategic alliances in overcoming challenging insurance problems.

Advantages And Disadvantages

Insurance companies undertake treaty reinsurance based on their varying risk tolerance levels. Below are the pros and cons of this reinsurance type that insurers must consider:

#1 – Advantages

  • Risk-Sharing: This approach fosters an environment of spreading and sharing insurance-related risks, such as mass losses, among various insurance companies.
  • Security: It protects the cedent’s equity from being exposed to anticipated risks involved in a particular class of policies.
  • Stability: It provides a higher degree of, even in unexpected conditions.
  • Cost Efficient: It saves operational and administrative costs of individual policy risk management by transferring entire policy classes.
  • Liquidity: It ensures sufficient liquid assets for further business operations or covering losses.
  • Increases Underwriting Potential: The ceding companies can maintain their solvency margins without elevating their costs by underwriting the class of policies that holds considerable risk.
  • Regulatory Compliance: Such reinsurance facilitates the cedent to maintain sufficient reserves and favorable solvency ratios as desired by the regulatory bodies.

#2 – Disadvantages

  • Insurance Risk: The reinsurance contract may not fully cover the overall risk involved in the insurance policies due to factors like poor pricing models, policy exclusions, etc.
  • Counterparty Risk: The reinsurer may fail to meet the contractual obligations due to poor communication, disputes, and fraudulent practices.
  • Credit Risk: The reinsurer may become incapable or lose interest in meeting the treaty obligations due to insolvency, weak financial position, regulatory consequences, or other adverse events.
  • Complexity: It becomes challenging for the reinsurer to handle multiple treaties with different terms and conditions simultaneously.
  • Reputational Impact: The ceding company’s reputation may be affected if the reinsurer has a poor market standing due to its low coverage ratio, lawsuits, regulatory actions, or negative financial position.

Treaty Reinsurance vs Facultative Reinsurance

Facultative and treaty reinsurance are two of the primary types of insurance available in the financial sector. While both aim to protect ceding companies, they differ in the following ways:

BasisTreaty ReinsuranceFacultative Reinsurance
MeaningThe reinsurer purchases the entire book of another insurer’s company’s specific class of policies.Such a reinsurance shields another insurance company for defined risk packages or single risks.
Scope of CoverageIt broadly covers a cedent’s certain class of insurance policies.It covers a single risk or a specific risk package chosen by the ceding insurer.
Underwriting ProcessUnderwriting is done for a specific class of insurance while collectively assessing the risk profile of that category.It requires separate underwriting for individual risk or risk packages by the reinsurer.
AgreementThe treaty is signed between the cedent and the reinsurer, assuming the overall risk of a certain insurance class.A short-term individual agreement between the ceding company and the insurer for specific risks.
Risk-SharingThe reinsurer has to share the complete risk in a particular insurance class, overlooking the individual policy risks.The reinsurer accepts or rejects risk-sharing proposals by matching the individual risk profile with their risk-taking capacity.
FlexibilityIt is comparatively rigid, covering the complete risk in a specific category of insurance.It is more flexible, allowing the acceptance or rejection of the reinsurance proposal based on individual risk profiles.
Cost-EfficiencyIt is more cost-efficient due to the lack of need for individual underwriting or risk assessment.It is comparatively expensive.
DurationLong-term partnershipShort-term agreement

Frequently Asked Questions (FAQs)

1. Is treaty reinsurance the oldest form of reinsurance?

No, facultative reinsurance is the oldest form of reinsurance, with treaty reinsurance being a later development in the insurance field.

2. What is non-proportional treaty reinsurance?

Non-proportional treaty reinsurance involves the reinsurer covering the insurance risk of the entire portfolio or category of policies beyond a particular threshold. This arrangement reduces the ceding insurer’s financial burden from significant losses.

3. What is casualty treaty reinsurance?

Casualty treaty reinsurance involves excess loss terms, covering businesses for general liability, automobile liability, workers’ compensation, etc. For instance, the insurance company that provides automobile insurance services for commercial vehicles can transfer its risk to a reinsurer under the casualty reinsurance treaty.

This has been a guide to what is Treaty Reinsurance. Here, we compare it with facultative reinsurance, and explain its examples, advantages, & disadvantages. You may also have a look at the following articles –

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