Riskonomics, Uncategorized

Proportional Reinsurance

The basic idea of proportional reinsurance, either treaty or facultative, is that each risk is being proportionally shared between the direct insurer (the retention proportion) and the reinsurer (the cession proportion).  Gross premium and all individual claims are then distributed following the proportion of risk distribution agreed at the outset.

Take an example of a property with a total sum insured of US$ 10 million.  The cedant retains 40% of the risk and cedes the rest, being 60%, to the reinsurer or a group of reinsurers.  Assuming a premium rate of 1 per mile, this translates into a gross premium for the whole risk of US$ 10,000. This premium is then distributed in the same proportion of 40%:60% (Diagram 1 below)

Diagram 1. Risk and premium distribution under proportional reinsurance.     

By ceding a part of the risk to the reinsurer, the cedant is entitled to receive a reinsurance commission to cover its own operating costs.  The purpose of the commission is to reimburse the cost incurred in procuring the business (the acquisition cost) in proportion of the premium ceded, and to make some contribution toward expenses for servicing the business.  This is logical since the reinsurer receives a share of the all-inclusive direct premium which includes the pure risk premium, acquisition costs and overheads.  The reinsurer, therefore, returns certain portion of the premium to the ceding company by way of reinsurance commission, expressed in an all-embracing percentage of the premium, as compensation for expenses incurred.  The level of reinsurance commission is determined by considering factors such as loss cost, actual acquisition cost incurred, profitability, investment income prospects, original pricing and the impact of competition in the market.

On the basis of a reinsurance commission of say 30%, the premium flows from the cedant to the reinsurer are shown in Diagram 2.  The reinsurer has to return 30% of its gross reinsurance premium (US$ 1,800) to the cedant as reinsurance commission, leaving a net reinsurance premium of 70% of the gross reinsurance premium (US$ 4,200) for the reinsurer. 

Under proportional treaty reinsurance arrangements, the reinsurer does not generally retain control over the adequacy of the direct premiums charged by the cedant to its policyholders, which will ultimately affect the performance or profitability of the treaty.  However, the reinsurer is able to set and vary the level of commission on the basis of the probable result of the treaty and past performance.  It may grant generous commission levels for excellent performance or penal levels when the business performance is poor.     

Diagram 2.  Premium flow of proportional reinsurance.
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Gross Premium

US$. 10,000

Gross Reinsurance Premium

US$. 6,000

Net Reinsurance Premium

US$. 4,200

Gross Retained Premium

US$. 4,000

Reinsurance Commission

US$. 1,800


Should a loss of US$. 6 million occurs, once again the same proportion applies in the distribution of the amount to the cedant’s retention and the reinsurer’s share.  This is shown in Diagram 3 below.

Diagram 3. Loss distribution under proportional reinsurance.
Adopted from Akoob, M. (2008). Reinsurance and Retakaful. In S. Archer, R. Karim, & V. Neinhaus, Takaful and Islamic Insurance: Concept and Regulatory Issues. Singapore: John Wiley & Sons (Pte) Ltd

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