What it means
Reinsurance is insurance for insurers. An insurer that writes many policies can face large or unexpected claims, so it buys cover from a reinsurer.
In a quota share treaty, the two parties agree on a percentage, say 40%, and that share of each policy goes to the reinsurer. The arrangement is proportional, which means the reinsurer shares in the results of the whole portfolio in the same proportion.
It receives 40% of the premium and pays 40% of every claim. This is simple to understand and administer, and it keeps the interests of both parties aligned.
The reinsurer also pays the insurer a ceding commission, which is a fee that helps cover the insurer's costs of finding customers, issuing policies and handling claims. The commission rate is negotiated and reflects the expected profitability of the business.
A higher commission means the insurer keeps more of the economics of the deal. Quota share treaties are popular for several reasons.
They reduce the capital an insurer needs to hold against its risks, which lets it write more business. They are also used by new insurers to enter a market with limited capital, and they bring in the reinsurer's expertise.
The downside is that the insurer gives up part of the profit as well as part of the risk. In a profitable year, the reinsurer takes its share of the gain, and the treaty does not protect against a single very large loss in a targeted way.
Many insurers therefore combine quota share with other types of cover, such as excess of loss.
In practice
Real-world examples.
Example
A young insurer in the motor market wants to write more policies than its capital allows. It signs a quota share treaty with a reinsurer taking 50% of each policy. The regulator is comfortable because the insurer's solvency position improves.
Example
A property insurer in a storm-prone region cedes 30% of its home policies to reinsurers. After a bad storm season, the reinsurers pay 30% of all the claims. The insurer's profit is lower in a good year, but the treaty protects its capital in a bad one. Management reviews the cession percentage each renewal.
Example
A specialist marine insurer wants to enter a new class of business where it lacks experience. It cedes 60% to an experienced reinsurer under a quota share treaty. The reinsurer's underwriting guidelines help the insurer price the risks correctly.
Formula
Calculation
Ceded premium = gross premium x quota share %; ceded loss = gross loss x quota share %; ceding commission = ceded premium x commission %
Suppose an insurer writes $10,000,000 of premium and cedes 40% under a quota share treaty. The ceding commission is 25%, and total claims are $6,500,000.
Step 1: ceded premium = $10,000,000 x 0.40 = $4,000,000.
Step 2: ceding commission = $4,000,000 x 0.25 = $1,000,000.
Step 3: ceded losses = $6,500,000 x 0.40 = $2,600,000.
Step 4: the insurer keeps premium of $6,000,000 and losses of $3,900,000, plus the $1,000,000 commission received.Case study
Seen in the real world.
Coastal Mutual is a fictional insurer used for illustration. It had grown quickly but its solvency position was getting close to the minimum requirement set by its regulator. The finance director proposed a quota share treaty ceding 40% of its home policies to a reinsurer.
In this illustrative story, the treaty released a good part of the capital that supported the policies, and the insurer received a ceding commission of 25% to cover its costs. Profits in the first year were lower, because the reinsurer took 40% of a healthy underwriting result. However, the company was able to keep writing new business, and it avoided a rushed share issue.
In the second year, a severe storm season pushed claims higher than expected. The reinsurer paid 40% of every claim, and the insurer's capital position held steady. The finance director later told the board that the treaty had done its job, even though it had cost some profit in quieter years.
Watch out
Common mistakes.
- Assuming quota share protects against one very large loss only. It shares every claim proportionally, so it is not a targeted cover for large single events.
- Ignoring the ceding commission. It is a major driver of the treaty's value to the insurer.
- Forgetting that profit is shared as well. The reinsurer receives its share of the gains.
Questions
People also ask.
What is the difference between quota share and excess of loss reinsurance?
Quota share shares every claim by a fixed percentage, while excess of loss pays only when a claim passes an agreed amount.
Why do insurers buy quota share?
They use it to reduce the capital they must hold, to grow faster and to gain from the reinsurer's expertise.
What is a cedent?
It is the original insurer that passes, or cedes, part of its risk to the reinsurer.
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