Ch4.pdf PDF - Features and Operation of Proportional Reinsurance Treaties

# Features and operation of proportional reinsurance treaties ## Contents - Introduction - Main features and operation of proportional reinsurance treaties - Main accounting methods - Commissions and deductions - Premium and claims reserves - Calculation of reinsurance premiums...

# Features and operation of proportional reinsurance treaties ## Contents - Introduction - Main features and operation of proportional reinsurance treaties - Main accounting methods - Commissions and deductions - Premium and claims reserves - Calculation of reinsurance premiums and claims recoveries - Cession and event limits - Case studies - Key points - Question answers - Self-test questions - Learning objectives ## Syllabus Learning Outcomes | **Learning Outcome** | **Number** | |---|---| | Main features and operation of proportional reinsurance treaties | 4.1 | | Main accounting methods | 4.2 | | Commissions and deductions | 4.3 | | Premium and claims reserves | 4.4 | | Calculation of reinsurance premiums and claims recoveries | 4.5 | | Cession and event limits | 4.6 | | Case studies | 4.1 | ## Learning Objectives After studying this chapter, you should be able to: - Explain the operation of the main types of proportional treaties. - Discuss alternative bases of cover. - Calculate earned and unearned premiums and claims recoveries. - Explain the main methods of accounting. - Describe the various types of commission arrangements including loss participation clauses. - Distinguish between premium and claims reserves. - Explain the use of cession and event limits. ## Introduction A reinsurance treaty is a method of reinsurance whereby the insurer and reinsurer enter into an agreement for the former to cede, and the latter to accept, all insurances offered within the limits of the treaty. This means that automatic acceptance is secured and there is an obligation for the reinsurer to accept all risks within the scope of the treaty. The insurer can, therefore, grant cover immediately for any proposal accepted within the limits of the treaty. In this chapter we look at the characteristics of proportional treaties and the ways in which they operate. Again, at the end of this chapter we have provided case studies to illustrate the practical application of proportional reinsurance treaties. **Non-proportional treaties will be examined in chapter 5**. ## Key Terms This chapter features explanations of the following terms and concepts: - Capacity - Commission - Cession limit - Event limit - Net retention - Quota share treaty - Claims reserve - Exposure - Portfolio transfer - Sliding scale - Clean cut accounting - Facultative carve-out - Premium reserve - Surplus treaty - Loss participation - Proportional reinsurance treaty - Underwriting year accounting ## Main features and operation of proportional reinsurance treaties There are two main types of proportional reinsurance treaty: - The first results in the sharing of all risks between the insurer and the reinsurers and is known as a **quota share treaty**, and - The second enables the insurer to retain the smaller risks while sharing proportionately the larger risks and is known as a **surplus treaty**. **We will also make some reference to facultative obligatory treaties in this chapter.** ### Quota share treaties A quota share treaty is an obligatory treaty where the insurer has to cede a fixed percentage of all its risks within agreed parameters. The reinsurer is then obliged to accept all the cessions made, usually subject to a maximum amount in any one cession. **Quota share treaties are usually expressed in 100% figures showing the 100% maximum sum insured agreed before allocating the reinsurer's share.** #### Operation of quota share treaties To help us understand how quota share treaties operate, we are going to use the example of an insurer’s taxicab account. The details of the reinsurance in this example are that the: - insurer retains 40% of all business written for its own account under its taxicab account, - reinsurer agrees to accept a 60% share of all business written under the insurer’s taxicab account, and - reinsurer agrees that the insurer should have the benefit of a 12% ceding commission to cover the costs of acquiring and managing the original business **The detail is shown in table 4.1.** | **Name of risk** | **Amount of premium** | **Reinsurer's share (net premium)** | **Ceding commission** | **Insurer's share** | |---|---|---|---|---| | Dodgy Cabs | £1,000,000 | £528,000 | £72,000 | £472,000 | | Ace Minicabs | £500,000 | £264,000 | £36,000 | £236,000 | | Pick-em-up | £2,500,000 | £1,320,000 | £180,000 | £1,180,000 | | Pubshut Cabs | £1,500,000 | £792,000 | £108,000 | £708,000 | *Net premium = gross premium ceded less ceding commission. *Retained net premium plus ceding commission. The ceding commission of 12% is deducted by the reinsurers and given back to the insurance company. So, for Ace Minicabs, for example, reinsurers would originally get £300,000 (60% of the premium) and they would then return 12% (£36,000) of this to the insurers as ceding commission. **If the losses shown in table 4.2 occurred, the reinsurer would pay its share of each loss.** | **Cab firm** | **Date of loss** | **Amount of claim, £** | **Insurer's share, £** | **Reinsurer's share, £** | |---|---|---|---|---| | Dodgy Cabs | 12/02/2018 | 20,000 | 8,000 | 12,000 | | Dodgy Cabs | 17/02/2018 | 120,000 | 48,000 | 72,000 | | Dodgy Cabs | 26/06/2018 | 10,000 | 4,000 | 6,000 | | Pick-em-up | 24/10/2018 | 2,500,000 | 1,000,000 | 1,500,000 | | Pick-em-up | 27/07/2018 | 3,000,000 | 1,200,000 | 1,800,000 | | Pubshut Cabs | 18/06/2018 | 150,000 | 60,000 | 90,000 | | Pubshut Cabs | 24/12/2018 | 70,000 | 28,000 | 42,000 | | **Total** | | **5,870,000** | **2,348,000** | **3,522,000** | As we can see in table 4.2, the reinsurer takes its share of the total amount of each loss, i.e. 60%. The ceding commission is not considered when looking at the claims, merely the respective shares, or proportion, as agreed by the insurer and reinsurer at the beginning of the contract. **The treaty limit would usually be expressed as:** _Maximum limit any one risk £3m for 100%. Reinsured's retention 40%._ The £3m is an underwriting limit, and the scope of the treaty is for all risks written by the reinsured for the agreed class with original sums insured of up to £3m. If the reinsured writes a risk with a sum insured above £3m, that risk would be outside the scope of the treaty and would be excluded. The exception would be if there is an agreement with the reinsurer for the 100% treaty limit to apply after any proportional facultative reinsurance. When written by the reinsurance company, this contract might be expressed as a 60% quota share of all business written in the motor department under its taxicab account, subject to a maximum cession any one risk of £3m. **It is important to realise that reference to 60%, or any other percentage when describing a quota share treaty, refers to the percentage ceded, and not the percentage retained by the insurer.** This would allow both the insurance company and reinsurance company to understand the parameters within which the reinsurance was written. The risks reinsured would be written under the taxicab account, so that all risks written under that account would be ceded through to the reinsurance. Risks written in the general motor account would not be included and the maximum risk accepted under the account would be £3m, limiting the size of risk that could be ceded (to 60% of £3m). Any risks in excess of this size would have to be reinsured by some other method, most likely a facultative arrangement. This type of treaty states the maximum that can be ceded in relation to any one risk. In the case of incidents involving a recognisable and identifiable event, such as a hurricane, the reinsurer will have to pay the stated proportion of claims for every risk, the total cost of which could be enormous. Therefore, it is common for quota share reinsurers to incorporate an event limit in the contract. This puts a cap on the liability of the reinsurer for such single incidents, irrespective of the total number of losses that would otherwise fall to the treaty. A cession limit may also be incorporated instead of, or in addition to, an event limit. This imposes a maximum limit that can be ceded in respect of specified types of risk. It is intended to restrict the reinsurer's liabilities, as opposed to its losses, in respect of a particular geographical location. **In this case the 100% treaty limit/cession limit, being the maximum to the treaty for 100%, is £3m. £3m is the maximum sum insured on any one policy that can be covered under the treaty in 100% figures.** **If the reinsured writes a policy for £3m that would be within the 100% treaty limit. At 60% the reinsurers share would be £1.8m.** **If the reinsured writes a policy with a £2m limit, the reinsurers share would be £1.2m.** In these examples the 100% amounts ceded to the treaty are £3m and £2m, shared 60% / 40% between reinsurer and reinsured. With a £3m maximum treaty limit for 100%, if the reinsured wrote an original policy for £4m, that would be excluded as it would be above the £3m / 100% treaty limit. In practice however, proportional facultative reinsurance is used, as long as the reinsurers allow use of proportional facultative reinsurance. If the reinsured writes an original policy with a £4m limit, they would need 25% facultative reinsurance: *25% x 4m = 1m to facultative reinsurers.* The 100% sum insured after facultative reinsurance is then reduced to £3m. £3m to the treaty for 100%, shared 60% reinsurer, 40% reinsured. ## Use of quota share treaties The use of quota share treaties is particularly appropriate in the following circumstances: - A **newly formed company needs a sufficiently large per risk capacity to enable it to attract business**, particularly in a market that has an excess of existing capacity. However, it may not have the capital base to support the size of acceptances required, nor the experience or reputation to develop a presence in an established market. A quota share treaty will provide operating capacity while enabling the insurer to fix its net retention at a level that matches its capital base. The reinsurer would prefer a quota share arrangement with greater opportunity to participate in the underwriting of each policy and to obtain an understanding of how the new business would be handled.<br> The reinsurer can also benefit from diversification in its own inward portfolio by accepting business in a class in which it does not have expertise: it can be more cost-effective for the reinsurer to avail itself of the other insurer’s expertise than to buy in or set up its own underwriting team. As the company grows, the percentage of the insurer’s retention can be increased, which allows a certain amount of expansion within existing arrangements. This also provides continuity in its reinsurance security, which is important, particularly in the first few years of a company’s development. - **Where the risks are homogeneous**, or similar, and have relatively uniform sums insured (as might be found in a household account), quota share treaties are useful where volumes are high, as the administration of the reinsurance is relatively simple and cost-effective when compared to other types. This is especially true if the type of business is written via a number of small branch offices or agents. The ease of operation of this type of reinsurance, again, may make quota share arrangements attractive to new or small companies with staff of limited experience administering their reinsurance programmes. - **An insurer wishes to expand its portfolio of inwards reinsurance business**, but this may only be achievable by giving some of its own business away through reciprocal exchanges. Quota share treaties provide an efficient method of arranging such transfers. - **An established insurer, together with its reinsurers, may have experienced a period or series of poor results under other less all-embracing reinsurance arrangements.** As a temporary expedient, a sign of good faith and to seek to maintain its reinsurance capacity, a quota share treaty may be arranged to restore the balance. With this type of reinsurance there can be no selection of the risks ceded to reinsurers. Therefore, if the original account is profitable this may be a preferred method of retaining the support of reinsurers. - **With a large insurance group operating on a worldwide basis, the ‘sharing’ of business by subsidiary companies within the group organisation can be a way of diluting the effects of losses in any one part of the organisation, without losing the overall benefits of the premium income from the business concerned.** - **It is often overlooked that the sharing of each and every risk on a proportional basis provides an insurer with a certain amount of natural perils or catastrophe reinsurance capacity.** ### Advantages and disadvantages of quota share treaties #### Advantages - The relationship between insurer and reinsurer is absolute - in such a context the reinsurer follows the fortunes of the insurer almost identically. - The accounting and reporting of business is simple. - No up-front costs: deposit premiums are not payable, as they are on non-proportional treaties. Balances are settled after submission of quarterly accounts, usually within 60 or 90 days of the close of each quarter. - Flexibility exists in increasing or decreasing the amount of quota share ceded at each anniversary. - There is no limit to the number of individual loss recoveries. - Unlimited cover is generally provided for aggregation of risk losses in a single loss event. #### Disadvantages - Since a quota share involves the cession of all business within the retention pattern, large amounts of income are ceded away. If the class of business is a profitable one for the insurer, this could be to its detriment. - A quota share treaty is inflexible. The insurer cannot choose to vary its retention risk by risk and select an amount below which it would retain the risk. - If the risk does not fall entirely within the scope or capacity of the treaty arrangements, the insurer must resort to the facultative method of reinsurance or retain the risk net. - Where a risk falls within the scope of the treaty arrangements, the company is bound by the treaty terms. The insurer cannot alter the retention or its underwriting practice where these details form an integral part of the treaty. It cannot deal with the risk in any other fashion; for example, it cannot make a new relationship with a different reinsurer unless there is an agreement in the treaty that further reinsurance can be sought and used for the benefit of the insured. - The reinsurer has limited or no input into the underwriting practices of the insurer, yet is still required to share in the outcome of the underwriting result. - A quota share treaty protection by itself still leaves an insurer vulnerable to natural catastrophe losses. #### Brexit and fronted quota share treaties Insurers located in European Union countries have ‘passporting rights’ which allow an insurer domiciled in any one EU country to write insurance for policyholders located in all other EU countries. Following the UK’s departure from the EU and the end of the Brexit transition period (31 December 2020), the passporting rights between the UK and EU countries no longer apply. An insurer located in the EU will not be able to write UK business and conversely a UK insurer will not be able to write risks for policyholders located in EU countries. To overcome this, some insurers have opened up branch offices or subsidiary companies. An EU insurer using this route would need to open a branch or subsidiary in the UK in order to continue writing UK business. A UK insurer would just need to open a branch or subsidiary in any one EU country in order to regain passporting rights throughout the EU and in other European Economic Area (EEA) countries. The subsidiary or branch route involves considerable investment with the capital requirements and the office and administration expenses involved. Subsidiaries and branch offices can also take a few years to establish. Another solution that some insurers have opted for is the utilisation of fronting quota share treaties. This would involve issuing policies in the name of the fronting insurer. The fronting insurer then cedes the business back to the original insurer through a quota share treaty. #### Facultative obligatory treaties Facultative obligatory reinsurance is a form of treaty for the placing of a number of individual cessions. You may recognise the commonly used abbreviation of ‘fac/oblig’. This type of treaty combines some of the principles of both facultative and treaty methods of proportional reinsurance. #### Operation of facultative obligatory treaties The capacity provided by a facultative obligatory treaty can, like a surplus treaty, be expressed as a multiple of the reinsured’s gross retention, that is, its line, or the part it retains for its own account. Often, however, it is simply a monetary limit, so this type of treaty can be described as lined or unlined. As with other types of proportional treaties, once a risk has been ceded, premiums and claims are allocated in the same proportion that the original liability was apportioned. We have already seen that there is no obligation to cede business on the part of the reinsured, and so risks attaching to such an agreement are likely to be fewer and larger than those ceded to the surplus treaty. Consequently, they are more likely to produce an unbalanced portfolio for reinsurers. #### Use of facultative obligatory treaties A facultative obligatory treaty may be needed purely to provide additional capacity to allow for the expansion and development of an existing account. It may also be used to allow an insurer to maintain sufficiently high acceptance limits on large or target risks, or where it is perceived that an accumulation of risk problems may arise. Alternatively, it may be used to protect certain specific types, or categories, of risks where the insurer deems it prudent to limit its own retention, due to the degree of hazard associated with the original business. For example, an insurer has automatic capacity to accept risks up to £100m. This is sufficient to enable it to write the risks that it is usually offered. In favourable market conditions, the insurer sees opportunities to write more business on a selected number of larger risks, but it needs more gross capacity if it is to be able to take them on. In order to offer its clients the capacity they seek, the insurer may choose to establish a facultative obligatory treaty. #### Advantages and disadvantages of facultative obligatory treaties ##### Advantages These arrangements are useful for risks that have already been allocated to existing quota share and surplus treaties, but where additional capacity is needed without the expense and uncertainty of the single risk facultative method being used. They represent a further source of additional cover for the insurer, once other options have been exhausted. ##### Disadvantages The obligatory element falls upon the reinsurer, which must accept such cessions once the insurer has decided to cede a risk. These treaties tend to generate small income for large capacity, and so are not always popular with reinsurers. This is not simply because results can often be poor, but also because small premiums relative to high exposures mean that a single claim may have a significant impact upon profitability. It follows that in market conditions that favour reinsurers, these arrangements tend to be in short supply and, where provided at all, offer commission rates and associated terms which are of no great advantage to insurers. They present a less attractive rate of commission to the reinsured due to the level of anti-selection present. ## Main accounting methods This section looks at common ways in which the transactions under a proportional treaty are accounted by the reinsured to the reinsurer. In this type of business the reinsured provides an account at stated intervals, generally quarterly but sometimes half-yearly. This sets out the remittance due to, and by, the reinsurer for the activity during each period. In essence, the reinsurer is credited with the premiums ceded and is debited with the commission allowed under the treaty, any taxes and charges for which it is liable, together with the losses paid. Other items, such as premium and loss reserve deposit movements, and any portfolio transfers are also credited or debited, and a balance is struck for the period. After the statement of account has been rendered and agreed, payment is made by the debtor, who could be the reinsured or the reinsurer, to settle the balance. ### Underwriting year accounting When a proportional treaty is put in place by a ceding insurer, the treaty takes cessions of policies incepting during the period of the reinsurance. The inception date of each policy issued by an insurer determines to which treaty year that policy is ceded. The reinsurer shares liability with the insurer for the duration of the original policy through the reinsurer receiving its ceded portion of the policy premium and paying its ceded portion of all losses from that policy. Irrespective of when a claim occurs and is settled, the reinsurer that receives the written premium on the underwriting year basis is the one that pays the claim. With this ceding and accounting method, the year of origin of the cession of the policy has particular importance. Underwriting year accounting ensures that the reinsurer shares the liability of the insurer under any given policy ceded to the treaty by booking all accounting transactions to the year of policy inception. It gives the true result of the business ceded, but it can prove an administrative burden since accounting information has to be produced and rendered to the reinsurer for settlement on a regular basis, each quarter or half-year, until there are no outstanding liabilities. ### Clean cut accounting The clean cut method is when premium and loss portfolios are transferred into and out of a year. Clean cut accounting shortens the lengthy underwriting year accounting process to, in effect, a single year. It does this by transferring the portfolio between the reinsurer of one year and the reinsurer of the next. The insurer can operate the treaty by accounting the earned premium to the reinsurer for a given year and recovering the incurred losses for the same period. In example 4.6, with clean cut accounting, the surplus treaty for the 2019 year would accept the written premium for the risk incepting 31 January 2020. However, with portfolio transfers any payment for the claim occurring on 3 April 2021 would fall into a later treaty year, and be recovered from the treaty incepting in 2020 or a later year depending on how long it takes for the claim to be settled. ### Premium and loss portfolio transfer The main reason for using premium portfolio transfers is to transfer unexpired liability under a treaty from one reinsurer to another. The portfolio transfer usually takes place on the anniversary date of the treaty. Therefore, if one reinsurer is to be relieved of its liability under the treaty for policies still in force at the end of a treaty period, in the last account of the year it will be debited with a portion of the premium it received in that year. It can also be relieved of its share of the liabilities for the outstanding claims at the end of the treaty period by being debited with an amount usually set between 90% and 100% of the ceding insurer's reserve. These premium and loss portfolio amounts will then be credited to the incoming reinsurer. The effect is to relieve the old reinsurer of any further liability in respect of the unexpired portion of the risks accepted under that treaty in the preceding years, as well as the outstanding losses at the end of the treaty year. The new reinsurer accepts the future liabilities from the unexpired policies at the date of transfer and the liability for settlement of outstanding claims from the previous and all preceding years. ## 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, such as excess of loss, the premium is set by reinsurers. It 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 usually unwilling to allow the reinsured any reduction in the reinsurance premium by way of commission. However, with proportional reinsurances where 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 from being offered a share in the 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. 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 the reinsurance to the reinsured. For a proportional treaty to be successful, it would be assumed from the start that it ought to be profitable in the long run. An insurer is in the business of trying to make an underwriting profit from the risks it writes and any reinsurer sharing that same business would expect to share in the benefits while committing themselves to a share of any overall loss. Original ceding commissions would be negotiated with this in mind. 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 the 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 insurer to intermediaries; and - ceding insurer’s administration costs. The most common forms of commission in use in such reinsurances are outlined in the following sections. ### Flat-rate commission The application of a flat-rate commission is commonly applied where a portfolio of business is: - expected to have very stable results, with the results in any one year not subject to significant fluctuations; and - not to any great extent exposed to variations in profitability that can be influenced by the way business is ceded to the treaty, as in the case of surplus or facultative obligatory treaties. The commission is shown in the reinsurance terms and conditions as a percentage of the gross premiums that will be ceded to the reinsurance. The percentage will differ on each reinsurance arrangement, depending upon the type of reinsurance, the class of business, previous results, geographical scope, market conditions and so on, but it should be sufficient to cover the ceding insurer’s own acquisition costs and make a contribution to its administrative expenses. However, reinsurers have their own expenses to bear in mind. Thus we find that flat-rate commissions are lower for facultative business than for treaties, and surplus treaty commissions are lower than for quota share arrangements. This is mainly due to the additional administration involved in the reinsurers’ offices and the greater scope for increased variability of results in surplus treaties. Another factor influencing the size of the flat-rate commission is whether the premiums are ceded to the reinsurers on an original gross basis, or are subject to deductions. It is not uncommon for some reinsurances to be ceded net of any original commissions. In such circumstances, it can be expected that the reinsurance commission will be reduced accordingly. ### Profit commission (flat-rate basis) If a treaty is profitable, then both the reinsured and reinsurers benefit from the agreement. If it is very profitable, the reinsured may seek an extra commission from reinsurers for giving them a share in such a good account. This payment would be called a profit commission and would most commonly be allowed on stable quota share and surplus treaties. The existence of a profit commission in the treaty would be seen as an incentive to the reinsured to underwrite a sound, profitable account. It can be difficult to determine a reasonable basis for calculating a level of profit commission that is fair to both the reinsured and its reinsurers. There are several methods of establishing a profit commission formula, but there are no hard and fast rules for determining the percentage of commission to be allowed on any resulting profit. This may be affected by many different factors: - How much will the market stand and what phase of the underwriting cycle is the market presently at? - Is the treaty part of a reciprocal exchange? - Is it a new treaty for the insurer? - Is the treaty being offered to a new reinsurer? - What part of the world does it come from? - What will be allowed for reinsurers’ expenses? - What will be the effect of any deficits in previous accounts? - Will the profit be averaged over a number of years of account? - What is the past profitability of the treaty? There are many variations in the formulae used for calculating a profit commission, but in each treaty the terms and conditions should show clearly the basis that is to apply. Two principal methods used to deal with the problem of fluctuations from year to year are: - **Average system:** Each year, the profit commission is based on the average of the aggregate treaty results for the current and preceding years, typically between three and five years in total. A deficit in any one treaty year is carried forward and set against profits in an ensuing year or years. It may be agreed that any deficit should be carried forward for no more than a specified number of years, e.g. three years. Sometimes it is carried forward to extinction. Whichever feature is used, it will be clearly identified in the ‘outgoings’ section of the profit commission statement. - **Deficit carried forward:** A deficit in any one treaty year is carried forward and set against profits in an ensuing year or years. It may be agreed that any deficit should be carried forward for no more than a specified number of years, e.g. three years. Sometimes it is carried forward to extinction. Whichever feature is used, it will be clearly identified in the ‘outgoings’ section of the profit commission statement. The profit commission can be collected either by the reinsured rendering a specific account after the close of the accounting year or by including it in the last periodic account for the year in question. To ascertain whether an account has made a profit or not, all the component parts relating to the profitability of the treaty need to be identified. All the relevant income from whatever source needs to be compared with all the relevant expenditure from whatever source. In the event of income exceeding expenditure, a ‘profit’ has been made and a profit commission could be calculated. The relevant details that may form part of the profit commission calculation can be summarised as follows: **Income:** - Premiums credited for the underwriting year; - Premium reserves from the previous year, if applicable; - Incoming premium portfolio and/or loss reserves from the previous year, if applicable; - Incoming loss portfolio, if applicable. **Expenditure:** - Losses and loss expenses paid during the underwriting year and outstanding loss reserves at the year end, if applicable, - Outgoing loss portfolio, if applicable; - Premium reserve at the year end, if applicable; - Outgoing premium portfolio, - Ceding commissions on premiums for the current year, taxes, fire brigade charges or similar levies paid by insurers, - An allowance for reinsurer’s expenses (usually a percentage of the ceded premiums), - Deficit, if any, carried forward from previous years. Net profit is the amount by which the credit items exceed the total of the debit items. The precise manner in which a profit commission is calculated varies from contract to contract and is agreed in the profit commission clause of the treaty wording. ### Sliding scale commission Profit commissions on a flat-rate basis reward the reinsured for a good result on a particular treaty, but are an inflexible mechanism. The incentive to do better has a limited appeal, and certainly does nothing for either party should the results be less profitable than expected. An alternative is to have commissions calculated on a sliding scale basis, which not only automatically rewards the reinsured for producing a good result but also takes into account the possibility of imposing a ‘penalty’ in the event of a poorer than expected performance. The reinsured debits the reinsurer with a provisional commission on premiums paid during the year. This commission would be adjusted at the end of the year. The adjustment is determined in accordance with an agreed variable table of commissions, linked directly to the loss ratio achieved by the treaty. The loss ratio is calculated according to the following standard formula: *Incurred loss for the year x 100 = loss ratio percentage* *Earned premium for the year* In this instance, the figures to be used would be arrived at as follows: **Incurred loss:** losses and loss expenses paid by the reinsurer during the year plus outstanding loss reserve at the end of the year less outstanding loss reserve at the end of the preceding year. **Earned premium:** premiums paid for the current year plus unearned premium reserve at the end of the preceding year less unearned premium reserve at the end of the current year. There will invariably be a negotiated minimum and maximum rate of commission and the precise terms of the sliding scale must be clearly set out in the wording of the treaty agreement. ### Loss participation or reverse profit commission While it can be seen that the sliding scale basis goes some way towards rewarding the reinsured for good results and protecting the reinsurers against worse than expected results, it does little in the event that the results of the treaty are exceptionally poor. A flat-rate profit commission achieves even less to address this possibility, being purely an extra reward for good performance. Proportional reinsurance has its foundations in ‘sharing’ arrangements - the reinsured and the reinsurer sharing in the fortunes of the original business. Therefore, if there is an expectation that heavy losses may be incurred, some form of loss participation clause may be adopted to ensure a more equitable distribution of the net loss between the reinsured and its reinsurers. This can be explained as a reverse profit commission situation, whereby the loss above an agreed loss ratio is redistributed so that the reinsured bears some portion of a very heavy loss rather than the reinsurers bearing the whole burden. An example of such a wording is: _In the event that the loss ratio for the treaty exceeds 100%, the reinsured bears 25% of all losses in excess of this figure._ In order to operate equitably between the reinsured and the reinsurer, any such clause should take a number of issues into account and seek to establish the obligations of both parties to the contract as unambiguously as possible. The key points to be addressed and included in any wording are: - definition of the extent of the reinsured’s liability, for example, ‘If the loss ratio of any treaty year exceeds X% the reinsured shall bear Y% of the amount by which the loss ratio exceeds X%’; - provision for how the loss ratio shall be calculated; - definition of incurred losses and earned premiums; - the limit of the percentage borne by the reinsured of earned premiums for each treaty year; and - when any such calculation shall be made. Such a clause would appear to penalise a reinsured, but it should be remembered that the intention is to redress any unusually heavy loss situation. ## Premium and claims reserves Premium reserves and claims (or loss) reserves are a means by which the reinsured may hold monies during the term of the treaty for later release to the reinsurer. The premium reserve deposit is a proportion of the ceded premium, whereas the claims or loss reserve deposit represents the estimated amount of losses outstanding at a given date. The retention by the reinsured of such deposits is a legal requirement in some countries. Premium reserves and claims or loss reserves are mainly held in cash or established by a letter of credit issued to the reinsured by the reinsurer on funds in a mutually acceptable bank. The letter of credit facility should clearly define the terms on which it is held by the reinsured and the drawing rights it has on it. ### Premium reserve deposits The premium reserve deposit was developed as a safeguard enabling a reinsured to meet justified claims in cases where the reinsurer, for whatever reason, could not meet its obligations. ### Claims or loss reserve deposits As with the premium reserve deposit, the outstanding claims or loss reserve deposit was developed to protect a reinsured in case a reinsurer could not meet its obligations. The deposit comprises the amount estimated to be the known outstanding losses to the treaty that have