Types of Treaty Reinsurance (Definition and Examples)

4 Types of Treaty ReinsuranceA reinsurance treaty is merely an agreement in 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,

Surplus,

Excess of Loss,

Excess of Loss Ratio (Stop-Loss), and

Pools.

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

100% = $10,00,000

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

100% =$100,000

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 predetermined percentage.

In spite of the above shortcomings, this type of arrangement is, however, particularly helpful for small
offices or for 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.

Related: What is Reinsurance? Definition, Types, Examples (Explained)

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 insurer’s own retention.

This means that the insurer can automatically make a gross acceptance of the risk to the extent of his
own retention, plus, the amount of retention multiplied by the number of lines for which treaty has
been made.

Example 1

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

= $100,00,000

Example-2

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

= $7,000,000

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 a 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.

Example-3

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:

ABC’s Retention: $1,000,000

Treaty consumes: (upper limit applies) $8,000,000

Automatic cover: $9,000,000

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 totally undesirable in this trusted profession.

MERITS

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

Demerits are very little and some of the minor ones are:

For big liability insurances or for 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 and every individual case, even though
they might have entries into ceding company’s account at periodical intervals.

This method is not suitable for new insurance companies.

Related: Facultative Reinsurance: How It Works Explained with Example

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 and every 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.

Example:

Proposition: Against all public liability insurances, the insurer decides to bear a loss up to $100,000 in
respect of each and every loss. The reinsurers agree to bear any balance amount beyond $100,000. The
loss is for $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 upper limit: $ 20,000

Therefore, Insurer bears $ 1,20,000

Reinsurer bears $ 80,000

$ 2,00,000

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 basically 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
so as to keep the loss ratio of the ceding company within the ‘predetermined ratio. The treaty may
contain an upper limit also.

Example

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

$8,000,000

Therefore,

Ceding Co. bears: $7,100,000

Reinsurers pay :$900,000

$8,000,000

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 for catastrophe losses.

5. Pools Treaty Reinsurance

Pools are basically 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 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.