Reinsurance is when an insurance company buys insurance. It does this to help cover its exposure on the insurance policies it has issued to its customers (policyholders). Reinsurance is a method that enables the spreading of risk across a number of financial backers.
A company that buys reinsurance is known as the "ceding" company. It is the primary insurer. A company that sells reinsurance is known as a "reinsurer."
Just like other insurance policies, a reinsurance policy is a contract. In the reinsurance market, such a contract is called a "treaty." The treaty transfers a portion of the risk from the insurance company to the reinsurer, as specified in the contract. So, the ceding company retains a portion of the risk and spreads the rest among its reinsurers.
Types of reinsurance
Facultative: Each treaty or cession is individually negotiated. So, the reinsurer has the faculty or option to accept or reject each individual risk presented to it. As well, the ceding company has the option to cede or not to cede each risk.
Pro-rata or proportional treaty: The ceding company and reinsurer share in the insurance, premium, and losses in specified portions. The reinsurer usually pays a ceding commission to the ceding company. Two types of pro-rata treaties are:
Quota share treaty: The reinsurer pays a certain percentage of all losses and receives a certain percentage of the premium.
Surplus share treaty: Same as above except with a retention amount specified. So, the reinsurer pays a certain percentage of all losses and receives a certain percentage of the premium over a retention amount. The percentage ceded can vary depending on the risk size or amount of insurance provided.
Example: risk insured for $100,000 with $40,000 treaty retention; reinsurer would accept 40% of premiums and losses.
Excess of loss treaty: Reinsurer pays losses only after the amount of loss exceeds the retention amount. Treaties can be set up in several ways:
per risk excess - protects ceding company from one large loss
per occurrence excess (catastrophe treaty)
aggregate excess (stop loss treaty) - once losses exceed aggregate retention, reinsurer covers all future losses