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Treaty Reinsurance

Definition

Treaty reinsurance is an agreement between the insurance company (the ceding company) and the reinsurer, in which the reinsurer agrees to cover specified ongoing risks over a period of time. This contract often covers multiple risks or a series of risk exposures. The agreement is typically pro-rata or based on an excess of loss and can be either obligatory or optional.

Phonetic

The phonetics of “Treaty Reinsurance” are:Treaty: /ˈtriːti/Reinsurance: /ˌriːɪnˈʃʊərəns/

Key Takeaways

1. Provision for Risk Transfer : Treaty reinsurance allows insurance companies to transfer a portfolio of risks to a reinsurer, thus spreading out their risk exposure, aiding them in underwriting policies that cover larger risks.

2. Profits and Losses : In this arrangement, both parties share in profits and losses. This makes treaty reinsurance a critical risk management tool for many insurance companies, especially in cases where large claims could potentially risk their financial stability.

3. Two Types – Proportional and Non-Proportional : Treaty reinsurance can be arranged in two main formats – proportional and non-proportional. In proportional agreements, the reinsurer takes on a set proportion of risk and premium from the ceding company. In non-proportional agreements (also known as excess of loss treaties), the reinsurer only covers losses that exceed a certain predetermined limit.

Importance

Treaty reinsurance is a crucial business/finance term, primarily relevant in the insurance sector. It is important because it revolves around risk management, allowing insurance companies to spread the financial risk they undertake when writing policies to another party or a reinsurer, thus ensuring their financial stability. With treaty reinsurance, this risk distribution is done under preset terms and conditions, making it a systematic, hassle-free process. In essence, it provides a safeguard for insurance companies against catastrophic losses and helps maintain their solvency while enabling them to take on a larger volume of policyholders. Over time, this enhances their capacity to endure potential large-scale payouts, hence, ensuring business continuity.

Explanation

Treaty reinsurance serves as a crucial risk management strategy in the insurance sector. Its main purpose is to provide cedents (insurance companies) with the capacity to mitigate risk exposure and fortify their financial stability. The concept facilitates a mechanism where cedent companies can transfer part of their potential liabilities or risks associated with underwritten policy contracts to a reinsurer. In such scenarios, the reinsurer agrees to cover a portion or all of the claims related to prespecified types of policies issued by the insurer. By doing so, treaty reinsurance becomes instrumental in ensuring that insurance companies can maintain solvency even in the times of high claims arising from catastrophic events, reducing the potential risk of bankruptcy.Moreover, treaty reinsurance can also enable cedents to enlarge their underwriting capacity, essentially allowing them to write more policies and generate additional revenue that otherwise might not have been possible due to risk constraints. With the reduction in net liability on individual risks, the insurer can accommodate more policyholders. This helps insurers to balance their portfolios and achieve efficient diversification of risk. Therefore, treaty reinsurance not only protects against financial stress but also offers avenues for business growth for insurers. In return for taking on the cedent’s risks and potential payouts, the reinsurer receives a share of the premiums collected by the cedent.

Examples

Treaty Reinsurance is an agreement in which the ceding company pays a premium and the reinsurer covers all losses up to a certain limit. It provides coverage for a specific percentage of the insured’s losses. Here are three real-world examples:1. **Hurricane Coverages**: In areas prone to natural disasters like hurricanes (Florida and Gulf Coast in the U.S), local insurance companies often use Treaty Reinsurance. For example, if a hurricane damages properties insured by a local company, the local insurer may not be capable of absorbing the costs. Under a Treaty Reinsurance arrangement, the reinsurer will cover the agreed-upon percentage of losses, helping the local company survive the sudden financial impact.2. **Health/Epidemic Insurance**: During the COVID-19 pandemic, health insurance companies worldwide faced a surge in claims. In such a circumstance, an insurance provider who previously established Treaty Reinsurance would pass a portion of these claims to their reinsurance provider, reducing the economic burden.3. **Aviation Insurance**: Because of the high risk and cost associated with aviation accidents, insurers often enter treaty reinsurance contracts to protect themselves against catastrophic losses. When the Air France Concorde crash occurred (2000), it resulted in large payouts due to the high value of the aircraft and significant loss of life. Insurers who had treaty reinsurance agreements would share the burden of these payouts with their reinsurers, protecting themselves from financial ruin.

Frequently Asked Questions(FAQ)

What is Treaty Reinsurance?

Treaty reinsurance is a type of reinsurance where the insurer agrees to cede and the reinsurer agrees to accept all risks within a specific category. These agreements are typically long-term, often for one year or longer, and automatic – they apply to all policies which the insurer issues within the agreed-on category of risk.

What are the types of Treaty Reinsurance?

Treaty reinsurance is usually classified into two types: Proportional and Non-proportional. In Proportional Treaty Reinsurance, the reinsurer accepts a fixed percentage of every policy that the insurer writes. Whereas, in Non-proportional Treaty Reinsurance, the reinsurer only pays out if the total collective losses exceed a pre-agreed level.

How does Treaty Reinsurance help insurance companies?

Treaty reinsurance allows insurance companies to provide coverage for large or high-risk policies without exposing themselves to excessive risk. By transferring a portion of the risk to a reinsurer, the insurer can safeguard its financial stability.

What is the difference between Treaty Reinsurance and Facultative Reinsurance?

Treaty reinsurance involves a contract between an insurer and a reinsurer, where the reinsurer agrees to cover all or a percentage of risks. In contrast, facultative reinsurance is more flexible, allowing the insurer to choose which individual risks to cede to the reinsurer.

Is Treaty Reinsurance necessary for every insurance company?

While not necessary for every insurance company, treaty reinsurance is a common practice used to mitigate financial risk. It is particularly beneficial for insurers that underwrite large number of policies or policies with significant potential liabilities.

How is the premium determined in Treaty Reinsurance?

The premium in treaty reinsurance is determined by several factors including the type and level of risk, the treaty’s terms, and past loss experience.

What is “retention limit” in Treaty Reinsurance?

Retention limit refers to the maximum amount of risk the insurance company is willing to assume from its insurance policy. Any risk beyond this limit is then ceded to the reinsurer.

Related Finance Terms

  • Ceding Company: This is the insurance company that initially underwrites the risk and later decides to transfer it to the reinsurer as part of the Treaty Reinsurance agreement.
  • Retention Limit: The maximum amount of risk which the primary insurer keeps for its own account. Above this limit, risks are passed on to the reinsurer.
  • Reinsurance Premium: The amount charged by the reinsurer to cover the risk accepted from the ceding company as part of Treaty Reinsurance.
  • Facultative Reinsurance: A type of reinsurance agreement where the reinsurer has the choice (or ‘facult’) to accept or decline individual risks proposed by the ceding insurer. This is in contrast to Treaty Reinsurance, where the reinsurer must accept all risks that fall within the terms of the agreement.
  • Surplus Share Treaty: A form of Treaty Reinsurance where the primary company and reinsurer agree to share the amount of risk, above a specified limit, according to a predetermined ratio.

Sources for More Information

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