What it means
Insurers take on risks from customers, but they cannot always carry all of that risk themselves. They pass part of it to a reinsurer, which takes a share of the premium in return for covering a share of the losses.
The insurer passing on risk is called the ceding company, and handing risk over is called ceding. In obligatory reinsurance, the treaty says that the ceding company must cede every policy that falls within the agreed class, and the reinsurer must accept it.
Neither side can pick and choose after the event. This is why the arrangement is also called treaty reinsurance.
The opposite approach is facultative reinsurance, where each policy is offered to the reinsurer separately and the reinsurer can accept or decline it. Facultative cover suits large or unusual risks, while obligatory treaties suit steady books of ordinary policies such as motor or home insurance.
Many insurers use both together. The treaty can be built in different ways.
In a quota share, the reinsurer takes a fixed percentage of every policy and of every claim, and in a surplus treaty the reinsurer takes the amount above a set retention. The reinsurer usually pays a ceding commission to cover the insurer's costs of selling and managing the policies.
For the business owner or finance manager, obligatory reinsurance matters because it frees up capital and steadies results. An insurer that has ceded part of its risk can write more policies without holding as much capital against a single bad year.
The trade-off is that it gives up part of the profit and depends on the reinsurer being able to pay claims. Accounting for the treaty has its own routine.
The ceded premium is deducted from the insurer's premium income, recoveries from the reinsurer are shown as assets until collected, and the net result is reported separately from the gross figures. Finance teams reconcile these balances with the reinsurer every quarter, since late settlement can tie up large sums of cash.
In practice
Real-world examples.
Example
A motor insurer with a large book of private car policies signs a treaty that cedes 40% of every policy to a reinsurer. Each new policy is covered automatically from the day it starts. The underwriting team no longer has to ask for approval on routine cases.
Example
A property insurer in a coastal region uses an obligatory treaty to pass on part of its home policies. After a severe storm, the reinsurer pays its agreed share of the claims without disputing individual policies. The insurer is able to keep paying customers quickly.
Example
A small specialist insurer writing marine cargo cover uses a surplus treaty to take larger shipments than its own capital would allow. The reinsurer takes the amount above the insurer's retention on each policy. The treaty lets the insurer compete for bigger clients.
Formula
Calculation
Ceded premium = total premium x cession percentage
Reinsurer's share of a loss = total loss x cession percentage
Ceding commission = ceded premium x commission rate
An insurer writes $4,000,000 of premium in a year and has a 30% quota share treaty. Ceded premium = 4,000,000 x 0.30 = $1,200,000. The insurer suffers claims of $1,000,000 on the covered book, so the reinsurer pays 1,000,000 x 0.30 = $300,000. If the ceding commission is 25%, the insurer receives 1,200,000 x 0.25 = $300,000 to help cover its own costs.Case study
Seen in the real world.
Northgate Mutual is a fictional insurer that wrote $10,000,000 of home insurance premium and held capital sized to its total risk. In this illustrative story, its management wanted to grow but regulators expected more capital for every new dollar of premium. The finance director negotiated an obligatory quota share treaty that ceded 25% of the home book.
Ceded premium came to $2,500,000, and the reinsurer paid a ceding commission that covered much of Northgate's acquisition costs. With less risk retained, Northgate was able to write more policies without raising fresh capital. In a later bad year, the reinsurer paid a quarter of the claims, which kept Northgate's results within its planned range. The finance director also began reviewing the credit standing of the reinsurer every year, because a treaty is only as strong as the party that must pay.
Watch out
Common mistakes.
- Thinking the insurer can choose which policies to cede. Under an obligatory treaty it must cede everything that falls within the treaty terms.
- Assuming reinsurance removes all risk. The insurer still depends on the reinsurer's ability to pay, which is called counterparty risk.
- Confusing obligatory with facultative reinsurance. Facultative cover is arranged policy by policy and can be refused, while obligatory cover is automatic.
Questions
People also ask.
Why do insurers buy obligatory reinsurance?
To reduce the volatility of results, to free up capital and to take on more business than their own capital would allow.
Is obligatory reinsurance the same as treaty reinsurance?
In practice yes, since the treaty creates the obligation on both sides.
What does the reinsurer get in return?
It receives a share of the premium and takes on the matching share of claims, and it earns a profit if the book performs well.
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