Chapter 4 - Features and operation of proportional reinsurance treaties

Question 1

The two main types of proportional reinsurance?

Answer 1

• the first results in the sharing of all risks between the insurer and the reinsurers and is known as a quota share treaty; and
• the second enables the insurer to retain the smaller risks while sharing proportionately the larger risks and is known as a surplus treaty.

Question 2

What is an event limit?

Answer 2

This puts a cap on the liability of the reinsurer for such single incidents, irrespective of the total number of losses that would otherwise fall to the treaty.

Question 3

What is a cession limit?

Answer 3

This imposes a maximum limit that can be ceded in respect of specified types of risk. It is intended to restrict the reinsurer’s liabilities, as opposed to its losses, in respect of a particular geographical location.

Question 4

When are quota shares used? What are the benefits?

Answer 4

• A newly formed company needs a sufficiently large per risk capacity to enable it to attract business, particularly in a market that has an excess of existing capacity.
• Where the risks are homogeneous, or similar, and have relatively uniform sums insured (as might be found in a household account), quota share treaties are useful where volumes are high, as the administration of the reinsurance is relatively simple and cost-effective when compared to other types.
• Quota share treaties carry the highest percentages of ceding commission compared with other types of proportional reinsurance arrangements.

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Question 5

What are the advantages of Quota Shares?

Answer 5

• Absolute relationship, reinsurer follows the fortunes of the insurer almost identically
• Simple accounting and reporting process
• No up-front costs, usually paid in quarters
• Flexibility exists at renewal for cession increase / decrease
• There is no limit to the number of loss recoveries
• Unlimited cover is generally provided for aggregation of risk losses in a single loss event

Question 6

What are the disadvantages of Quota Shares?

Answer 6

• Large premium cession
• Inflexible in terms of retention
• Where a risk falls within the scope of the treaty, the company is bound by the treaty terms
• The reinsurer has limited or no input into the underwriting practices
• Can leave insurer and reinsurer in a vulnerable to Nat cat events

Question 7

What is the purpose of a surplus?

Answer 7

Proportional arrangement which allows a reinsured to retain a proportion of risk at a desired retention level.

Question 8

When are the positives of surplus treaties?

Answer 8

• Allows a reinsured to vary its retention depending on the type of risk and level of hazard
• Automatic capacity available upon a particular class and size of risk providing it falls into treaty conditions
• Greater premium retention
• No up front costs
• Insurer receives a ceding commission
• No limit to amount of losses recoverable
• Unlimited cover usually provided for aggregation of risk losses in a single loss event

Question 9

What are the negatives of surplus treaties?

Answer 9

• Insurer stands by its chosen retention
• Retained premium is still less than non prop cover
• Admin heavy

Question 10

What are the main accounting methods for proportional insurance?

Answer 10

• Underwriting year accounting
• Clean cut accounting

Question 11

What is underwriting year accounting?

Answer 11

• Underwriting year accounting is described as an accounting method where the original policy inception date is used to determine which underwriting year a loss should fall into.
• i.e. a reinsurance treaty running from 1/1/21 running to 31/12/2021 is considered 2021 underwriting year. A policy which incepts on 1/4/21 suffers a loss on 1/3/22 would fall into the 21 underwriting year.

Question 12

What is clean cut accounting?

Answer 12

• The clean cut method is when premium and loss portfolios are transferred into and out of a year.
• It shortens the lengthy underwriting year accounting process to a single year.
• It does this by transferring the portfolio between the reinsurer in one year to a reinsurer in another year.

Question 13

What is the main reason for using a premium portfolio transfer?

Answer 13

• The main reason for using premium portfolio transfers is to transfer unexpired liability under a treaty from one reinsurer to another.

Question 14

What is the difference between earned and unearned premium?

Answer 14

• Earned premium refers to to the insurance premium that corresponds to the expired part of the policy period. It represents the amount of premium that the insurer has ‘earned’ because hey have provided coverage for the time period that has passed.
• Unearned premium refers to the the insurance premium that corresponds to the duration of cover which has not yet been provided.

Question 15

What is meant by ‘fixed percentage’?

Answer 15

• Under this method a simple percentage (usually 35%) is applied to the premium accounted to reinsurers in the outgoing year, and is paid to reinsurers in the incoming year as a premium portfolio.

Question 16

What is the Eighths basis?

Answer 16

Under this method, each of the four calendar quarters is divided equally into two, making eight blocks of premium. Each block has an earned and unearned element and a fraction of eight is applied on a progressive earned/unearned basis.

Question 17

What is the twenty fourths basis?

Answer 17

Under this method, which provides greater precision than the eighths basis, each calendar month is divided equally into two, making 24 blocks of earned and unearned premium. A fraction of 24 is applied on a progressive earned/unearned basis.

Question 18

How does a transfer of portfolio occur?

Answer 18

• Where the reinsurer wants a new treaty to assume the portfolio of business or wants a new reinsurer to assume the portfolio

Question 19

What governs the size and manner in which commission is calculated?

Answer 19

• type of reinsurance arrangement
• past history of profitability
• state of the reinsurance market
• original commission paid by reinsured
• ceding insurers admin costs

Question 20

Where is flat-rate commission applied?

Answer 20

Where a portfolio of business is:

• Expected to have stable results
• Not to any great extent exposed to variations in profitability that can be influenced by the way business is ceded to the treaty

Question 21

What do we mean when we refer to cessions being made net of original
commissions?

Answer 21

An example would be where a fire and property insurer allows its own introductory
sources 15% commission on business received. Instead of ceding 100% of relevant
gross premiums to its reinsurers, it cedes only 85%.

Question 22

What is the purpose of a flat-rate commission?

Answer 22

Reinsured’s might allow an additional commission based on the profitability of
the business, such as a profit commission on a flat-rate basis. The commission is shown in the reinsurance terms and conditions as a percentage of the
gross premiums that will be ceded to the reinsurance.

Question 23

What is a profit commission? Why is it used?

Answer 23

If a treaty is profitable, then both the reinsured and reinsurers benefit from the agreement. If it is very profitable, the reinsured may seek an extra commission from reinsurers for giving them a share in such a good account.

Question 24

What are the two main methods of calculating a profit commission which deals with fluctuations?

Answer 24

Average system - Each year, the profit commission is based on the average of the aggregate treaty results for the current and preceding years, typically between three and five years in total.

Deficit carried forward - A deficit in any one treaty year is carried forward and set against profits in an ensuing year or years.

Question 25

What is the principal advantage of the ‘deficit to extinction’ method from the
reinsurer’s point of view?

Answer 25

‘Deficit to extinction’ mitigates a situation where the reinsurer would pay out more
profit commission only a few years after the treaty has sustained a major loss year,
which could happen if a deficit is only brought forward two or three years, and gives
the reinsurer the possibility of recouping profits in ensuing years. Such a situation
works to the reinsurer’s advantage.

Question 26

What is the purpose of a sliding scale commission?

Answer 26

automatically rewards the reinsured for producing a good result but also takes into account the possibility of imposing a ‘penalty’ in the event of a poorer than expected performance.

Question 27

What is the purpose of a reverse profit commission?

Answer 27

whereby the loss above an agreed loss ratio is redistributed so that the reinsured bears some portion of a very heavy loss rather than the reinsurers bearing the whole burden

Question 28

What are the two methods a reinsured holds monies during the term of a treaty for later release to a reinsure?

Answer 28

• Premium reserve deposit
• Claims or loss reserve deposit

Question 29

What is the purpose of a premium reserve deposit?

Answer 29

The premium reserve deposit was developed as a safeguard enabling a reinsured to meet claims in cases where the reinsurer, for whatever reason, could not meet its
obligations.

Question 30

What is the purpose of a claims reserve deposit?

Answer 30

The deposit comprises the amount estimated to be the known outstanding losses to the treaty that have been advised but not yet settled

Question 31

What is a cession limit?

Answer 31

To help the reinsured keep and maintain accurate records of total exposures to the portfolio, procedures need to be in place to monitor the total amount of business accepted. This, in turn, will allow adequate levels of reinsurance to be put in place. The actual amount of the cession limit is negotiated between reinsured and reinsurer.