Treaty Reinsurance

A treaty reinsurance contract is a contract between an insurance company and a reinsurance company. According to the terms of the contract, an insurance company (also known as a cedent) passes on the risks of a class of policies to a reinsurance company. The reinsurance company will take on these risks for a certain fee. This article will discuss certain important aspects of treaty reinsurance, such as:

• How does a treaty reinsurance contract work?
• Importance of treaty reinsurance
• Types of treaty reinsurance
• Treaty reinsurance example
• Treaty reinsurance vs facultative reinsurance

How does a treaty reinsurance contract work?

Insurance companies write a staggering amount of policies. The volume of policies handled by large insurance companies is truly massive. An insurance company can easily write millions of policies a year. The more policies that an insurance company writes, the more premium it receives. That being said, along with additional premiums, the risk exposure of the insurance company also increases.

There could be a situation where a disproportionately large number of insurance claims are made in a particular year. How can an insurance company prepare for these expenses while simultaneously maintaining its financial position? The answer is treaty reinsurance.

An insurance company will get into a treaty reinsurance contract with a reinsurance company, where the reinsurance company will provide coverage for a host of insurance policies that the insurance company wrote. Whenever there is a claim made for any of these policies, the reinsurance company will compensate the insurance company proportionately.

This arrangement works for all 3 parties, the insurance company, the reinsurance company, and the end policyholder. The idea is to transfer the risk to safer and more stable hands so the risk of default is mitigated.
An example of a reinsurance company is Warren Buffet’s Berkshire Hathaway Speciality Insurance. It enters into large-scale reinsurance contracts due to the financial strength and risk-bearing capacity of the company.

Importance of treaty reinsurance

Mitigates risk of default: Even if the insurance company defaults on a policy claim, the treaty reinsurance company will step in and handle the claim.

Strong hands bear risk: A treaty reinsurance contract ensures that the strongest hands bear the greatest risks. This is of great importance to the underlining health of an economy.

Protection against natural anomalies: An insurance company may not be in a position to handle a massive claim during natural anomalies such as huge earthquakes, tornadoes, Tsunamis, etc. The risk of default would be high due to the sheer number of claims. A reinsurance company will step in during these times and handle the situation.

Types of treaty reinsurance

There are 5 types of reinsurance treaties, they are:

• Quota share
• Surplus
• Pools
• Excess of loss
• Excess of loss ratio

Treaty reinsurance example

Let us say that an insurance company wants to mitigate risk on its health insurance portfolio. The ceding company enters into a treaty reinsurance contract with a reinsurer. The terms of this reinsurance contract state that the reinsurer will indemnify the insurance company (only health insurance policies) to the extent of $50 million once the insurance company’s expenses go beyond $100 million.

This means that the reinsurance company will pay the insurance up to a maximum of $50 million for all claim-related expenses over the threshold of $100 million. A treaty reinsurance contract can be set up in a variety of different ways, depending on the situation.

Treaty reinsurance vs facultative reinsurance

A Facultative reinsurance contract is a specialized contract where the reinsurance company decides to indemnify specific risks. These contracts are generally negotiated as one-off contracts and not blanket contracts.

For instance, an insurance company would like to write an insurance policy for a large shipping project, but they are not willing to expose themselves to all the risks associated with this project. To mitigate a certain amount of risk associated with this specific project, the insurance company can enter into a facultative reinsurance treaty.