Treaty reinsurance is basically an agreement between 2 parties. One is the insurance company that gives away the responsibility and another is the reinsurance company. Reinsurer agrees to accept the reinsurance business according to the policy agreement. Reinsurance is a process of transferring risks from insurers to reinsurers. Reinsurance contracts are of three main types. The facultative reinsurance, treaty reinsurance, and excess of loss reinsurance. But, here we are going to take you through the type of treaty reinsurance in detail.
What Are The Different Type Of Treaty Reinsurance?
While underwriting new insurance policies, the companies agree to take additional risks. The more number of policies underwritten, the higher is the risk.
Read Also: What is Reinsurance? Its Definition, Types, and Examples!
Treaty reinsurance is of those mediums that help them in dealing with risky situations. Treaty reinsurance comes in following types:
#1. Quota Share
In Quota Share, the ceding insurer cedes a predetermined section of all of its business in certain classes. It cedes it to the reinsuring company. Now, the reinsurer accepts that section or proportion in lieu of a premium amount. Let us understand it with an example:
Direct Insurer: 20%
All Reinsurers: 80%
Risk Assumed: $10,00,000
Now, the direct insurer will handle $ 2,00,000 and all reinsurers will handle $ 8,00,000
If we take the same example and change the risk assumed to $ 100,000 then the distribution will change. Direct insurance handles $ 20,000 and all reinsurers handle $80,000. In both examples, the same types of risk are there, but the amount changes. In the second example, the insurance company could even keep the complete amount. But the quota share treaty reinsurance doesn’t let them do so. The quota share arrangement is apt for small companies or a new company.
#2. Surplus Treaty Reinsurance
The second type of treaty reinsurance is surplus treaty reinsurance. Just as the name suggests, direct insurers agree to reinsure the surplus only after retention. The reinsurance company consents to take such cessions according to the foredetermined upper limit. The surplus treaty reinsurances are usually arranged in a line. Each line is equal to the retention limit of the insurer. It clearly means there is an automatic gross acceptance of the risk up to the extent of the retention limit of the insurer.
Example: An insurance company signs fire insurance for a paper mill. The fire insurance is of the amount of $20,000,000. The retention of the company is of an amount of $2,000,000. Suppose there is a 9-line treaty. So the arrangement is:
Insurance company’s retention: $2,000,000
Treaty Consumption: $18,000,000
Let us take another example where the insured sum is $14,000,000. Here, the treaty upper limit is $2,000,000. The arrangement is:
Insurance company’s Retention: $2,000,000.
Treaty Consumes: $12,000,000. (6-line treaty)
#3. Excess Of Loss
The third type of treaty reinsurance is an excess of loss treaty reinsurance. Excess of loss is totally different from other types of treaty reinsurance. Under this type of reinsurance, the insured sum doesn’t make any base at all. In this type, the insurer takes into consideration loss in business. He calculates loss under each class of his business. And the loss in business must not exceed the predetermined amount. If anything like that occurs then the reinsurer has to pay the remaining amount of loss. Similarly, reinsurer won’t pay anything if the amount of loss is low.
Example: The insurer comes to the decision that he can bear a loss of up to $200,000 considering all aspects of loss. Now, the reinsurance companies agree to pay remaining amount after $200,000. The total loss is $300,000 and the upper limit is $80,000. Now, the insurer bears the loss of $200,000. Due to the set the upper limit of $80,000 for reinsurers, the reinsurers bear the $80,000. Again the insurer has to bear the loss of the remaining $20,000. So in total, the insurer bears the loss of $2,20,000. This arrangement works good in case of huge liability insurances and also is great for catastrophe loss protection.
#4. Excess Of Loss Ratio
It is also sometimes called the Stop Loss reinsurance. It is quite different from the latter arrangement but the basis is a loss in both the cases. The relationship is created amongst gross claim and the gross premium throughout a year. The insurance company agrees upon a gross loss ratio up to the limit it can bear.
According to the arrangement, if the sum of all the losses exceeds the set loss ratio then the reinsuring company pays the remaining loss. The main goal is to keep the gross loss ratio of the insurance company in the set limit. The excess of loss ratio treaty can have an upper limit too.
Example: Suppose the XYZ insurance company arranges an excess of loss ratio treaty with a reinsuring company. It agrees to bear the loss of amount that doesn’t exceed 60% of the gross premium of any given class. Reinsurance company agrees to bear any balance amount to maintain an 80% limit.
Total premium collected= $10,000,000
Loss= $9,000,000
XYX insurance company bears (60% of the premium) = $6,000,000
Reinsurer pay for 80% of $3,000,000= $2,400,000
Again there is an upper limit so XYZ insurance bears= $600,000
Therefore, XYZ bears total: $6,600,000
Reinsure pays for $2,400,000
We realize that without an upper limit, the reinsurers would have paid the full amount of $3,000,000.
Read Also: Difference Between Facultative and Treaty Reinsurance
Due to the upper limit, there is a distribution of a predetermined loss ratio. Liability insurances make use of this treaty reinsurance type.
Final Words
Other than these, pools treaty reinsurance is another type of treaty reinsurance. It could be a quota share or surplus with its different arrangements. Here, different member countries or companies come together to share their claims and premiums. These pools work in respect of dangerous classes of businesses. Another case where pool treaties work is when the whole market is weak. In such instances, these pool treaties are quite useful.
We hope this article gave you an insight into types of treaty reinsurance with examples. In case of queries, please contact us through the comment section.
