Now that we know what reinsurance is all about and the two categories underwhich it falls, i.e Treaty Reinsurance and Facultative Reinsurance. Lets take a look at how this two categories are structured.
Part 1: Proportional Reinsurance.
Depending on how the Risks, Premiums and losses are shared between the Cedant and the Reinsurer, Treaty/ Facultative Reinsurance can either be of proportional or non- proportional nature. i.e a Proportional Treaty Reinsurance or a Non Proportional Facultative Reinsurance.
What do we mean when we say "of a proportional or non- proportional nature"?
With a Proportional Form of Reinsurance Cover, the Insurer and the Reinsurer share the sums insured (Liabilities) in a clearly defined proportion. This proportion (for Qouta Share Treaties) is usually stated in the schedule of the treaty agreement. In addition to sharing the sums insured, the premiums and claims are equally shared in the same proportion. To give you a better understanding of this, consider a basic proportional arrangement between Insurer A and Reinsurer Z. Insurer A enters into a treaty agreement with reinsurer Z to buy Reinsurance protection for 40% of the risks it underwrities under its fire business. under the proportional arrangment, Reinsurer Z will bear 40% of the liabilities (sums insured) for every fire risk. In addition to this, 40% of the premium will be transfered to Z as the cost for the protection. When a loss arises, Z will pay A 40% of the losses incurred. You will notice that the proportion is stated as 40% and applies across the liabilities, premiums and Losses.
There are three main forms of proportional reinsurance i.e Quota Share, Surplus and Facultative-Obligatory (Fac-Oblig).
Quota Share.(Q.S) - With this form, the Cedant is obligated to cede and the Reinsurer obligated to accept a fixed proportion (expressed as a percentage) of each and every risk written by the cedant for example 40% : 60% . This means the cedant retains 40% and cededs 60% of each and every risk written by it. Consider for example an apartment building with a sum insured of 1,000,000.00: the cedant will retain 400,000(40%*1,000,000.00) and cede 600,000.00 (60%*1,000,000) to the reinsurer. Under the Q.S arrangment,there is a fixed upper limit within which the arrangment holds. any amount above this limit will be reinsured with any other form of reinsurance or facultatively. what does this mean? if in the above example the fixed upper limit was 10,000,000.00, then risks with sums insured of upto 10,000,000 will be absorbed by the qouta share arrangment while risks with sums insured exceeding 10,000,000.00 the amount of risk in excess of the 10,000,000.00 can be reinsured with an alternative arrangment e.g surplus or facultative.
Detailed Example A. An apartment Block with a sum insured: 1,000,000, Premium: 2,000.00, Loss Amount, 500,000.00
Risks Sharing: Insruer A retains 40% = 40%*1,000,000.00 = 400,000.00 and Cedes to the Qouta Share Treaty 60% (Portion beared by the Reinsurer) = 60%*1,000,000.00 = 600,000.00
Premium Sharing: Insurer A: 40% *2,000.00= 800.00 and Reinsurer Z: 60%*2,000.00= 1,200.00
Loss Sharing: Insurer A: 40% *500,000.00= 200,000.00 and Reinsure Z: 60%*500,000.00= 300,000.00
Lets now consider an example in which the Q.S arrangment has an upper limit.
Detailed Example B. An apartment building with a sum insured: 12,000,000.00, Premium of 240,000.00, Loss Amount of 1,000,000.00 and Quota Share treaty limit of 10,000,000.00.
You will notice in this example that the Sum Insured of the apartment building exceeds the Qouta Share treaty limit by 2,000,000.00. This means that the first 10,000,000.00 of the 12,000,000.00 ( 83.3%) will absorbed by Insurer A's Qouta Share Treaty, while the extra 2,000,000.00 (16.7%) will be Reinsured with an alternative arrangment lets say facultative reinsurance. In case you are wondering how the percentages came about; (10,000,000/12,000,000.00*100= 83.3%) and ( 2,000,000.00/12,000,000.00*100= 16.7%). Under the Qouta Share treaty therefore, Insurer A Retains 40% of 83.3%= 33.32%, and Cedes 60% of 83.3% =49.98% to Reinsurer Z.
Of the entire sum of 12,000,000.00, the proportions born by the cedant, reinsurer and the facultative reinsurer will be 33.32% for Insurer A , 49.98% fore Reinsurer Z and and 16.7% for faculative reinsurer. This same proportions will apply across premiums and losses.
Risk Sharing: Insurer A retains 33.2%= 33.2%*12,000,000.00=3,984,000.00, Cedes to Reinsurer Z 49.98% = 49.98%*12,000,000.00= 5,997,600.00, Facultative takes 16.7% = 16.7%*12,000,000.00= 2,004,000.00
Premium Sharing: Insurer A 33.32%* 240,000.00= 79,968.00, Reinsure Z: 49.98%*240,000.00=119,952.00 and Facultative 16.7%*240,000.00=40,080.00
Loss Sharing: Insurer A:33.32%*1,000,000.00=333,200.00 Reinsurer Z: 499,800.00 Facultative: 16.7%*1,000,000.00= 167,000.00
One of the main benefits of a quota share arrangment lies in its simplicity. It is simple to operate and admninister and is often recomeneded for a new company starting bussines or an already existing company begining a new a class of bussines for which it has no prior experiance or statistical data.
The downside however to this kind of treaty is that the cedant has no control over the risks he choses to retain. Of every risk, good or bad, small or large, the cedant must share with the Reinsurer as per the proportions set out in the agreement (Treaty).
Surplus Reinsurance: Under this form of reinsurance, the ceding company agrees to cede and the reinsurer agrees to accept any amount of risk in excess of the ceding company's retention. In otherwords, the Reinsurer only offers protection for the excess amount of any one risk that exceeds what the ceding company can retain on its net account.
If for example, a ceding compay retains only 100 of any one risk for its net acccount. for a Building of 400.00, the surplus treaty will offer protection for the extra 300 while the ceding company retains 100.00
The Size/Capacity of a surplus treaty is determined as a multiple of the ceding company's retention and is normally expressed in terms of "lines". For a company with a gross retention of 100.00, a 10 line surplus treaty will have a capacity of 1000 (10*100). The total capacity of the treaty will therefore by the retention + surplus capacity = 100+ 1000= 1100. *Remember: one line= cedants retention . In cases where the qouta share and surplus forms are combined under one treaty, the gross retention constitutes the qouta share treaty. This form of treaty is used *mainly for property lines of business and may be arrangend in multiples i.e First Surplus Treaty, Second Surplus Treaty and so on......
For a risk that exeeds the capacity of the surplus treaty, the excess amount is reinsured facultatively.
To better understand how the approtinment of risks is done in a surplus treaty, consider the following example.
Insurer A has a retention of 1,000,000.00,and 6 Line surplus treaty (6*1,000,000.00= 6,000,000.00). The Total Treaty capacity of A= 1,000,000.00+6,000,000.00= 7,000,000.00.
Scenario 1: Company X places a fire business with A with the following details. Sum Insured: 5,000,000.00, Premium : 800,000.00 and surffers a loss of 4,000,000.00
The Proportion of Risk retained by A will be 1,000,000/5,000,000.00 =20%. and Proportion reinsured under the surplus treaty will be the amount in excess of the 1,000,000 i.e 4,000,000/5,000,000.00= 80.0%
The Premum and losses will then be apportioned based on the same proportions in which the sum insured has been aportioned: Premium Sharing. Retained -20% *800,00.00=160,000.00, Surplus Treaty- 80%*800,000.00=640,000.00 Losses Sharing: Retained 20%*4,000,000.00=800,000.00, Surplus: 80%*4,000,000.00=3,200,000.00
Scenario 2: Company X places a fire business with A with the following details. Sum Insured: 10,000,000.00, Premium : 1,000,000.00 and surffers a loss of 3,000,000.00
you will notice with this example that, the sum insured exceeds the treaty capacity of 7,000,000.00. so the extra 3,000,000.00 will be reinsured facultively while the initial 1,000,000.00 and 6,000,000.00 will be retained and reinsured under the surplus treaty respectively.
The apportionament of risk will be as thus: Retained- 1,000,000/10,000,000.00= 10%, Surplus Treaty- 6,000,000.00/10,000,000.00= 60.0% and Facultative = 3,000,000.00/10,000,000.00= 30.0%
The proportions obtained above will then be used to allocate the Premiums and Losses as detailed below.
Premium: Retained- 10%*1,000,000.00=100,000.00, Surplus- 60.0%*1,000,000.00= 600,000.00 and Facultative-30.0%*1,000,000.00=300,000.00
Losses: Retained- 10%*3,000,000.00= 300,000.00 Surplus: 60.0%* 3,000,000.00= 1,800,000.00 and Facultative- 30.0%*3,000,000.00= 900,000.00
It is important to note that only risks that exceed the company's retentions are reinsured under the surplus. If the surplus capacity is exhasusted, then facultative arrangment can be sought. A company not wishing to rely on facultative reinsurance may decide to increase the capacity of its surplus treaty by increasing the number of lines or obtain an additional surplus treaty. i.e A second surplus treaty or third surplus treaty
Unlike the Quota Share, with a surplus treaty, the adminstration costs are relatively high and more expertise and experiance is needed to manage. Also there is the possibilty of an imbalance in the portfolio reinsured where the Cedant retains all the good risks and transfers the less desirable risks to the surplus treaty.
Facultative - Obligatory (Fac-Oblig): Normally used for placing individual risks, This Form is a Union between the principles of facultative and treaty methods with the distinguishing feature being that it is facultative for the cedant and obligatory for the reinsurer. The cedant may cede a risk or not but if he does cede, the reinsurer must accept the risk ceded.
A high degree of trust should exist between the insurer and reinsurer so that the reinsurer can receive a resonable spread of risks from the cedant. This form of reinsurance is less favourable with most reinsruers since the onus is on the reinsruer to accpet all risks that the cedant decides to include leaving them exposed to the cedant selecting the most hazardous risks from its portfolio.
With the Fac-Oblig, the cedant does not have to worry about having to seek support facultative support for risks that exceed his treaty capacity as he is already assured of support from the reinsurer.
Next Article: Understanding Reinsurance: Part 2 - Non Proportional Reinsurance (Excess of Loss).
