1. OPERATION OF PROPORTIONAL REINSURANCE TREATIES

2. Types of Proportional Treaties
There are two main types of proportional treaty. Quota share and Surplus
Quota Share treaties
A quota share treaty is an agreement whereby the ceding company is bound to cede and the reinsurer is bound to accept a fixed proportion of every risk accepted by the ceding company. The reinsurer thus shares proportionally in all losses and receives the same proportion of all premiums less commission.
For example, a ceding company may decide to arrange an 80% quota share treaty covering all its fire business. The retention of the company will be 20% of each and every risk and the proportion to be ceded to the reinsurer 80%. Thus, the reinsurer will cover 80% of all risks, will receive 80% of premiums (less commission) and pay 80% of all claims falling under the treaty.
Advantages
The main advantages for a ceding company of a quota share are:
Simplicity of operation.(accounting and reporting of business)
Higher commission and better terms are obtainable
Flexibility exists in increasing or decreasing the amount of quota share ceded.
Unlimited cover is provided for aggregation of risk losses in a single loss event.

3. Disadvantages
The ceding company cannot vary its retention for any particular risk and thus it pays away premiums on small risks which it could well retain for its own account.
The sizes of risks retained are not homogeneous as the ceding company retains a fixed percentage of all risks written and which are of varying sizes.
A quota share treaty is inflexible. No choice of selecting a retention exists for the insurer.
The advantages to a reinsurer are:
The reinsurer receives a share of each and every risk. There is no selection against him and he participates in the business written to a larger extent than under other types of reinsurance.
The reinsurer obtains a larger share of profits from the ceding company than would be obtained under any other type of treaty.
The quota share treaty is best suited for:
•New ceding companies or companies entering into a new class of business or a new area. This would be the best way to get reinsurers to participate in a portfolio with unknown experience and limited spread.
•A ceding company which wishes to accept reinsurance business itself and has to provide a share of its own business in reciprocity.

4. The Surplus Treaty
A Surplus treaty is an agreement whereby the ceding company is bound to cede and the reinsurer is bound to accept the surplus liability over the ceding company's retention.
A Surplus treaty thus allows the ceding company to reinsure under the treaty any part of the risk, i.e., the surplus, which it is not retaining for its own account. Thus, if a certain risk is wholly retained, there is no surplus left to place to the treaty. When speaking of a surplus treaty, it is usually said that the treaty is for, say, 20 or 30 lines. This means that the treaty will accept a maximum of 20 or 30 times the ceding company's retention; a line being the amount of the ceding company's retention.

5. Operation of a surplus treaty
The mechanics of ceding a risk under a surplus treaty do not differ from those of an individual facultative proportional cession. However, there are substantial differences in the creation of any surplus treaty.

6. If a claim of £ 500,000 occurred, the insurer and reinsurers would share the loss proportionate to the risk they undertook, as illustrated in table 4.5

7. Once the terms and conditions of a surplus treaty have been finalised, the insurer is obliged to cede all risks greater than its chosen retention and falling within the scope of the treaty agreement. The reinsurer is obliged to accept all such cessions.
Both contracting parties, the insurer and reinsurer, have identified obligations under the treaty and are automatically bound in advance to transact business in the manner specified, with no freedom of choice available to either party.
Whereas an individual facultative cession has to be specifically agreed between the parties, a cession to a proportional treaty is of immediate effect.

8. Second and third surplus
There may be the first, second and perhaps third and fourth surplus treaties rising in ascending order. The fundamental point to remember is that a risk must be ceded through each treaty in turn; namely that the capacity of the first surplus must be utilised in priority to the second surplus, then the second in priority to the third surplus and so on.

9. The advantages of Surplus reinsurance to the ceding company are:
Only the portion of the risk which exceeds the company's retention is reinsured. The insurer is thus allowed to retain a greater proportion of its income.
As the ceding company retains a fixed monetary limit (as opposed to a fixed proportion under a Quota Share) the portfolio it retains is homogeneous.
By retaining a larger amount of good risks and a smaller amount of the poor ones, the ceding company can keep more profitable business to itself than it gives to its reinsurers.
A surplus treaty allows the insurer to vary its retention upon a particular risk.
There is automatic capacity available upon a particular class and size of risk (provided that such cession falls within the treaty conditions)
The insurer receives a ceding commission, usually sufficient to pay the acquisition costs and expenses, together with an additional contribution to reward underwriting profit.

10. Disadvantages
The principal disadvantage to the ceding company is: high cost of administration as experienced persons must be employed to determine the retention for each and every risk according to type, quality, exposure and calculating the premium retained and the premium going to reinsurers accordingly. However the use of computers has reduced this administrative burden to a large extent.
Lower ceding commission than under quota share treaty
The insurer stands or falls by its chosen retention.

11. Commissions and deductions
The cost of reinsurance to an insurer is determined by the amount of premium that it must pay to its reinsurers. With non-proportional treaties (excess of loss) the premium is set by reinsurers and is not a direct sharing of the premium for any original risks, as is the case with proportional treaties and most facultative reinsurances. The reinsured has not sustained any acquisition or administration costs directly attributable to the reinsurance risk being offered to the non-proportional reinsurers. The risk is frequently the reinsured’ s own net retained liability in respect of all of the business it underwrites in a particular class or account. Consequently, reinsurers are unwilling to allow the reinsured any reduction in the reinsurance premium by way of commission.
However, with proportional reinsurances where the reinsurers are participating in and sharing the fortunes of an original book of business obtained by the reinsured, it can be seen that they potentially benefit by being offered a share in original risks directly. They would not otherwise have been able to obtain this share without considerable expense on their part and without a contribution to the costs of running the account.

12. Therefore, in these circumstances it is reasonable for the reinsured to seek the recovery of some of the administration and acquisition costs incurred in the production of the original portfolio of business. This recovery is achieved by the application of ceding commissions to the reinsurance premium, thereby reducing the ‘cost’ of reinsurance to the reinsured.
The size and manner in which any commission is calculated depends upon the:
Type of reinsurance arrangement concerned
Past history of profitability for the risk or account concerned
State of reinsurance market which influences how much reinsurers will be prepared or have to allow in order to underwrite the reinsurance
Original commission paid by the ceding company to intermediaries
Ceding company’s administration costs.

13. MOST COMMON FORMS OF COMMISSION IN USE
Flat-rate commission
This is very easy to operate as the commission payable is calculated by applying an agreed percentage to the premiums ceded (less returns and cancellations). If a treaty has business emanating from different geographical areas, there may be different rates of commission applying to the different locations.
Sliding scale commission
This method has been developed to allow the ceding company to receive more commission when the treaty is profitable and to minimize the loss to the reinsurer in unprofitable years.
The rate of commission is based on the loss ratio of the treaty during any one treaty year or during any one underwriting year. The loss ratio is usually calculated as the percentage that incurred losses bear to earned premiums, as follows:
Incurred losses x 100
Earned premiums 1

14. For example, where earned premiums are K 10,000 and incurred losses are GBP 5,000, the loss ratio is 50%.
“Earned premiums” Definition
Premiums ceded and included in the accounts for the year
Plus: Reserve for unexpired risks (premium reserve) brought forward from previous year (plus or minus portfolio premiums)
Less: Reserve for unexpired risks (premium reserve) at the end of the current year.
“Incurred losses” Definition
Losses paid and included in the accounts for the year
Plus: Outstanding losses (loss reserve) at the end of the current year
Less: Outstanding losses (loss reserve) at the end of the previous year (plus or minus portfolio losses).
There are variations to the above formula and these are:
a. Incurred losses x 100
Written premium 1
b. Paid + outstanding losses ) Underwriting Year
Written premiums ) Basis

15. As the information required to calculate the actual rate of commission payable is not known until the end of the year in question, there is always an arrangement for the payment of a provisional commission.
The loss ratio, when calculated, is compared with an agreed scale and the commission will be as indicated. However, there are fixed upper and lower limits to the scale.
The operation of a sliding scale tends to stabilize the results under a treaty, reducing the profit to the reinsurer in the good years and the loss in the bad years.

16. Overriding Commission
When a reinsurer receives business as an inward retrocession, the reinsurer will allow the ceding company an additional commission (overriding commission) over and above any original commission payable.
The overriding commission payable by the reinsurer may be calculated in various ways, i.e., on gross, on net, or partial net premiums, and this will be clearly stipulated in the treaty wording.
Brokerage
When a reinsurer receives a share of a treaty through a broker, the reinsurer will normally agree to pay a brokerage. The broker will either include his brokerage in the statement of account for the business, or render a separate brokerage account. The percentage of brokerage payable is applied to the premiums written on a gross, net or partial net basis and again, this will be clearly stipulated in the contract.

17. Profit commission
This is additional to the flat treaty commission and is offered by the reinsurer as an incentive to the ceding company to promote good underwriting. Thus, if the treaty earns a profit based on an agreed formula, reinsurers are charged an additional commission.
When a profit commission is allowed to a ceding company, normally:
1. for purposes of calculating the commission, the gross profit (i.e., reinsurance premiums paid less claims) is reduced by an allowance for reinsurer’s expenses;
2. provision is made either to carry forward past losses or to calculate the commission only on the aggregate results of a number of years;
3. the profit commission is subject to annual adjustment until all claims included in the calculations are settled.

18. The method of calculating profit commission is set out in the treaty wording and generally, is as follows:
1) Income
a) Premiums ceded in the current year;
b) Premium reserve from the previous year or premium portfolio credited;
c) Claims reserve from the previous year or claims portfolio credited.
2) Outgo (expenditure)
a) Commission paid in the current year, including other charges such as premium taxes;
b) Claims paid during the current year;
c) Reinsurer’s management expenses;
d) Premium reserve at the end of the current year or premium portfolio debited;
e) Claims reserve at the end of the current year or claims portfolio debited;
f) Deficit brought forward from previous statement.
The surplus, if any, of “income” over “outgo” shall constitute the net profit for the year.

19. There are two types of profit commission statements: those on an “underwriting year” basis and those on an “accounts year” basis.
“Underwriting Year” basis
A profit commission on an underwriting year basis requires all figures for the same underwriting year, irrespective of the account year in which these are included, to be related back to the same year for the purposes of determining the profit of that underwriting year. It is general practice, where this type of profit commission applies, to defer the preparation of the first statement until at least one year after the end of the underwriting year; adjustment statements are then rendered in accordance with the treaty terms until all liability has expired. Sometimes there is a provision to close an underwriting year after a specified period and transfer any outstanding liability to the next open underwriting year. All subsequent account figures relating to preceding underwriting years are then included in the profit commission statement for the earliest open underwriting year.
This is a method that is expensive to administer.
“Accounts Year” basis
A profit commission on an accounts year basis requires all figures for the same treaty period, irrespective of any division by underwriting year, to be included in the same profit commission statement.
A profit commission on an accounts year basis would not be adjusted in subsequent years, as long as the treaty remains current.

20. PRICING
The price of insurance is derived from the risk premium (which is the claims expenditure including a loading for fluctuations) plus external costs (acquisition costs/agents’ commission)plus internal costs (administration expenses) plus profit.
The price of proportional reinsurance is directly related to the percentage of liability assumed by the reinsurer. Whatever share of the risk that the reinsurer assumes, it obtains the same share of the original insurance premium less any agreed amounts (equals reinsurance premium).
Thus, the price of proportional reinsurance is the reinsurer’s percentage of the original premium, less any reinsurance commission, profit commission and overriding commission but with the additional cost to reflect any loss participation.

21. In determining the price of reinsurance, the following will be considered:
Analysis of the Cedant’s portfolio
Reinsurers will look not only at the basic losses of the portfolio, i.e the normal losses suffered in any given year, but they will explore the potential for extraordinary losses, i.e. those single losses that could have a significant impact on the whole account.
2. Loadings
3. Commissions and brokerage

22. ACCOUNTING ISSUES
Premiums, losses and commissions together make up the three most important aspects of the statements of account that are, in general, sent from the insurer to the reinsurer.
Underwriting year basis
Under the underwriting year basis, the year of origin of the cession of the risk is of particular importance. Not only will the premium for the risk be ceded to that year but any claims arising will also be ceded to that year.
Example
Surplus reinsurance treaty incepts 1st July 2002 and runs for 12 months.
Underlying construction all risk policy incepting 31st January 2003 and running for 18 months.
Claim occurs 3rd April 2004
Even though the policy incepts in 2003 and the claim occurs in 2004, they will be accounted into the treaty account for the underwriting year 2002.

23. 2. Year of account ‘clean cut’ basis
The method above does give the true result of the underwritten business but it can prove an administrative burden as accounting information has to be produced on a regular basis (generally quarterly) until such time there are no further outstanding liabilities. In order to facilitate technical accounting, reinsurers have devised another method called ‘clean cut’.
The difference between ‘clean cut’ and underwriting year basis is that premium, commissions, expenses and losses are accounted in the treaty underwriting period in which they occur, irrespective of the year of origin of the risk and date of any loss.

24. In our underwriting year basis example, the surplus treaty would cover all accounting entries made between 1st July 2002 and 30 June It is therefore likely it would accept the premium for the risk incepting 31st January 2003, but any payment for the claim occurring on 3rd April 2004 would fall into a later accounting period and affect the treaty incepting in 2003 or 2004.
An allowance is made at the end of the treaty period for any unearned premium(this is premium that has been paid in that year of account for risks that substantially fall under the following year) and outstanding losses. The identified amounts are then transferred into or out of a particular treaty. This is known as a portfolio transfer.

25. END