A proportional treaty is a significant aspect of insurance and reinsurance arrangements, providing a method for spreading risk among multiple parties. Let’s explore this concept in straightforward terms to understand its role in the realm of insurance and finance.
A proportional treaty is an agreement between an insurer or reinsurer and a ceding company where the risks and premiums are shared proportionally based on predetermined terms and conditions. Unlike excess-of-loss treaties where the reinsurer covers losses exceeding a specified threshold, proportional treaties allocate a portion of both premiums and losses to the reinsurer in proportion to their agreed-upon share of the risk.
Now, let’s delve into the key aspects of proportional treaties:
- Sharing of Risk and Premiums: The primary characteristic of a proportional treaty is the proportional sharing of both risks and premiums between the ceding company and the reinsurer. Under this arrangement, the reinsurer agrees to cover a predetermined percentage of the risks assumed by the ceding company in exchange for a proportional share of the premiums generated by the insurance policies. This allows the ceding company to spread its risk exposure and maintain sufficient capacity to underwrite new business.
- Calculation of Proportional Shares: The proportional shares of risks and premiums allocated to the reinsurer are typically determined based on agreed-upon percentages specified in the treaty. These percentages may vary depending on factors such as the type of risk, the reinsurer’s financial strength, the ceding company’s underwriting capacity, and market conditions. Common methods for calculating proportional shares include quota share treaties, surplus treaties, and sliding scale treaties.
- Profit and Loss Sharing: In addition to sharing premiums and risks, proportional treaties often include provisions for sharing profits and losses between the ceding company and the reinsurer. Profit-sharing arrangements may involve the distribution of underwriting profits, investment income, or surplus funds generated from the reinsured business. Similarly, losses incurred under the proportional treaty are shared between the parties based on their proportional participation, with the reinsurer covering a predetermined percentage of the losses.
- Example of Proportional Treaty: Let’s consider an example of a property insurance company entering into a quota share treaty with a reinsurer to manage its exposure to catastrophic risks.
- Sharing of Risk and Premiums: Under the quota share treaty, the reinsurer agrees to assume 30% of the risks associated with the property insurance policies underwritten by the ceding company. In return, the reinsurer receives 30% of the premiums generated by these policies.
- Calculation of Proportional Shares: The proportional shares are determined based on the agreed-upon quota share percentage specified in the treaty. For example, if the ceding company collects $1 million in premiums from property insurance policies, the reinsurer’s share would be $300,000 (30% of $1 million).
- Profit and Loss Sharing: In the event of underwriting profits or losses, both the ceding company and the reinsurer share the outcomes in proportion to their respective shares of the risk. If the ceding company experiences a loss of $500,000 on the reinsured business, the reinsurer would cover $150,000 (30% of $500,000) of the loss.
In conclusion, proportional treaties play a crucial role in the insurance industry by allowing insurers to share risks and premiums with reinsurers on a proportional basis. By spreading risk exposure and leveraging the financial strength of reinsurers, ceding companies can enhance their underwriting capacity, manage volatility, and improve their overall risk management strategies.
Reference:
- Clarke, R., Gleeson-White, J., & Devine, D. (2017). Understanding Insurance Law (6th ed.). Routledge.