What it means
The alternative approach, facultative reinsurance, means offering each individual risk to a reinsurer who can accept or decline it. A treaty removes that negotiation entirely: once the treaty is signed, every qualifying policy is covered from the moment it is written, which is far more practical for a book of thousands of small policies.
Treaties come in two broad families. Proportional treaties, such as quota share, split premiums and claims in a fixed ratio, while non-proportional treaties, such as excess of loss, leave the insurer to pay claims up to an agreed level and the reinsurer to pay above it.
The commercial reason to use treaty reinsurance is capital efficiency. An insurer's regulator limits how much business it can write relative to its capital, so ceding a share of premium to a reinsurer frees up capacity to write new policies without raising fresh equity.
The pricing mechanism that surprises outsiders is the ceding commission. The reinsurer typically pays the insurer a percentage of the ceded premium to reimburse the cost of acquiring and administering the business, since the insurer did the underwriting and pays the broker.
The nuance is that treaty reinsurance transfers risk but not responsibility. The original policyholder has a contract with the insurer alone, so if the reinsurer fails to pay, the insurer must still settle the claim in full, which is why counterparty credit quality is scrutinised as carefully as price.
In practice
Real-world examples.
Example
A small regional insurer wants to grow its household book from 20,000 to 50,000 policies but lacks the capital. A 40% quota share treaty lets it write the extra volume immediately, with the reinsurer taking 40% of both premium and claims and paying a ceding commission that covers most of the acquisition cost.
Example
A commercial property insurer buys an excess of loss treaty that pays anything above $5,000,000 on a single event, up to $80,000,000. A warehouse fire producing a $22,000,000 claim leaves the insurer paying $5,000,000 and the reinsurer $17,000,000.
Example
A specialist marine insurer adds a clause to its treaty excluding vessels over a certain tonnage. When it later wants to insure a very large container ship, that risk falls outside the treaty and must be placed facultatively as a one off arrangement.
Think of it
“Treaty is automatic reinsurance for a category of risks-ongoing agreement, not case by case.
Formula
Calculation
Under a quota share treaty: ceded premium = gross premium x cession percentage; recoveries = gross claims x cession percentage; ceding commission = ceded premium x commission rate
A motor insurer writes $80,000,000 of gross premium and cedes 30% under a quota share treaty with a 25% ceding commission. Ceded premium = $80,000,000 x 30% = $24,000,000, leaving $56,000,000 retained.
Claims for the year come to $60,000,000, so the reinsurer pays $60,000,000 x 30% = $18,000,000 and the insurer retains $60,000,000 - $18,000,000 = $42,000,000. The ceding commission is $24,000,000 x 25% = $6,000,000, so the insurer's underwriting result is $56,000,000 + $6,000,000 - $42,000,000 = $20,000,000 before its own expenses, and the gross loss ratio of $60,000,000 / $80,000,000 = 75% is unchanged on a net basis at $42,000,000 / $56,000,000 = 75%.Case study
Seen in the real world.
This is a fictional, illustrative scenario. Stonebridge Mutual, an invented regional insurer of small commercial properties, wrote $80,000,000 of premium a year across roughly 14,000 policies and had never used proportional reinsurance, relying instead on an excess of loss treaty for large single claims.
A severe hailstorm produced 2,300 separate claims, none individually large enough to reach the excess of loss threshold, but together costing $31,000,000. The fictional insurer paid every one from its own capital, its solvency ratio fell close to the regulatory minimum, and it had to stop writing new business for two quarters.
The remedy was to add a 30% quota share treaty alongside the existing excess of loss cover. The following year the same kind of accumulation would have cost Stonebridge only 70% of the total, the ceding commission offset much of the premium given away, and the freed capital allowed the mutual to resume growth rather than pause it.
Watch out
Common mistakes.
- Assuming a treaty covers everything the insurer writes, when the wording defines a specific class, territory and size band, and anything outside it is uninsured.
- Believing that ceding risk removes the obligation to policyholders, when the insurer remains fully liable if the reinsurer cannot pay.
- Judging a treaty on premium ceded alone and ignoring the ceding commission, which can make a seemingly expensive treaty the cheaper option overall.
Questions
People also ask.
What is the difference between treaty and facultative reinsurance?
A treaty covers a whole class of business automatically, while facultative reinsurance is arranged risk by risk with the reinsurer free to decline each one.
Why would an insurer give away profitable premium?
Because ceding premium releases regulatory capital and smooths results, which usually allows more total business to be written than keeping every risk would.
How does quota share differ from excess of loss?
Quota share splits every claim in a fixed proportion from the first dollar, while excess of loss only responds once a claim passes an agreed level.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%