What it means
Reinsurance is insurance for insurers. When an insurer writes a large policy, such as one covering a factory worth $5 million, a single big claim could damage its finances.
It can protect itself by agreeing in advance to pass part of the risk to a reinsurer in exchange for a share of the premium. In a surplus treaty, the insurer decides how much it will keep on any one risk, called its retention or line.
If a policy is within the line, the insurer keeps all of it. If the sum insured is bigger, the surplus above the line is ceded, meaning passed to the reinsurer, up to a stated maximum, which is usually a multiple of the line.
The key feature is that the split is proportional. If the reinsurer takes 75% of a policy, it receives 75% of the premium and pays 75% of any claim.
The insurer also usually receives a ceding commission from the reinsurer to cover its costs of finding and managing the business. This differs from a quota share treaty, where the insurer cedes the same percentage of every policy.
In a surplus treaty the percentage varies from policy to policy, depending on the sum insured, so small risks stay almost entirely with the insurer. Surplus treaties are common for property insurance, where policy sizes vary widely.
The nuance is that the insurer must keep careful records, because the share ceded is calculated for each policy separately. It also depends on the reinsurer's creditworthiness, because it needs the reinsurer to pay when a claim arises.
Accounting teams track the ceded premiums, claims and commissions in separate accounts from the insurer's own business.
In practice
Real-world examples.
Example
A property insurer retains $1 million on any one building and cedes the rest of larger policies to its reinsurers. It can therefore accept a $6 million warehouse policy without risking a large share of its capital.
Example
A growing insurer wants to write more commercial property cover but has limited capital. It signs a surplus treaty with a reinsurer, which reduces the capital it must hold against large policies and allows it to expand.
Example
A reinsurance accountant reviews quarterly statements from a ceding insurer. She checks that the ceded premium, claims and commission were calculated using the correct share for each policy, and queries three where the sums insured appeared to be wrong.
Formula
Calculation
Share ceded = (sum insured - retention) / sum insured, up to the treaty limit
Suppose an insurer keeps a retention of $500,000 per risk, and its treaty gives capacity of 9 lines, which is $4,500,000 of cover for the reinsurer. The insurer writes a factory policy with a sum insured of $2,000,000 and a premium of $40,000. The ceded amount is 2,000,000 - 500,000 = $1,500,000, so the share ceded is 1,500,000 / 2,000,000 = 75%. The reinsurer receives 40,000 x 0.75 = $30,000 of premium. If a fire causes an $800,000 loss, the reinsurer pays 800,000 x 0.75 = $600,000 and the insurer pays the remaining $200,000.Case study
Seen in the real world.
Beacon Mutual is an illustrative, fictional property insurer with $60 million of capital. Its chief underwriter wanted to win a contract to insure a chain of cold storage warehouses, with individual sums insured up to $8 million.
Keeping such large risks would have used too much of the company's capital, so the finance director arranged a surplus treaty. Beacon would keep $1 million on each risk and cede the remaining part, up to nine times its retention.
On an $8 million warehouse, 87.5% was ceded, which is 7,000,000 divided by 8,000,000. In this illustrative case, a $2 million fire loss cost Beacon only $250,000, and the company could win the contract without endangering its solvency.
Watch out
Common mistakes.
- Confusing a surplus share treaty with a quota share treaty, when the first cedes a varying share of each policy and the second cedes a fixed share.
- Assuming the reinsurer takes only the claims, when it also receives a proportional share of the premium.
- Forgetting the treaty limit, so that a very large policy may need extra cover above the capacity of the treaty.
Questions
People also ask.
What is the retention in a surplus treaty?
It is the maximum amount of each risk that the insurer keeps for its own account before passing the surplus to the reinsurer.
Why is the ceded share different for each policy?
Because it is calculated as the part of the sum insured above the retention, so bigger policies have a larger share ceded.
What is a ceding commission?
It is a payment from the reinsurer to the insurer that helps cover the costs of writing and administering the business.
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