10.2 Forms and Types of Reinsurance

10.2 Forms and Types of Reinsurance

Quick Summary: Reinsurance is structured under two foundational legal forms: Facultative Reinsurance, where individual risks are negotiated optionally on a case-by-case basis, and Treaty Reinsurance, where an entire defined portfolio is ceded and accepted under an obligatory contractual agreement. Treaties are broadly classified into Proportional Reinsurance (encompassing Quota Share and Surplus treaties), where premiums and losses are apportioned in predetermined mathematical ratios, and Non-Proportional Reinsurance (encompassing Excess of Loss per Risk, Catastrophe XL, and Stop Loss), where the reinsurer pays only the portion of a loss exceeding the cedant's agreed retention (deductible or attachment point).

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The Two Foundational Forms: Facultative versus Treaty Reinsurance

Every reinsurance placement, regardless of class, operates through one of two primary contractual forms:

1. Facultative Reinsurance

The term facultative originates from the Latin facultas, meaning freedom or choice. Under facultative reinsurance, reinsurance is negotiated for a single, specific risk on an individual case-by-case basis:

• Mutual Freedom of Contract: The ceding company has complete freedom to offer the individual risk to a reinsurer or retain it. Crucially, the reinsurer possesses absolute freedom to accept the proposal, decline it outright, or stipulate specific exclusions, warranties, and premium rates.
• Full Underwriting Disclosure: The cedant must submit full underwriting particulars to the reinsurer, including survey reports, past loss records, construction specifications, and safety measures.
• Application Scenarios: Facultative reinsurance is utilized for:
  1. Exceptionally high-value risks that exceed standard treaty capacity (e.g., an oil refinery or mega-infrastructure project).
  2. Abnormal, hazardous, or non-standard risks excluded under automatic treaties (e.g., ammunition storage facilities or chemical synthesis plants).
  3. Experimental or novel risks where the direct insurer lacks loss data and seeks technical validation from a specialist reinsurer.
• Limitations: High transaction costs and administrative friction. Negotiating terms on individual risks creates delays, during which the direct insurer may be unable to confirm unconditional coverage to the policyholder.

2. Treaty Reinsurance

Treaty reinsurance is an overarching, obligatory agreement negotiated in advance to cover an entire defined class or portfolio of insurance business (e.g., all commercial property or private motor policies written by the cedant during a specified calendar year):

• Mutual Obligation: The agreement is strictly obligatory. The ceding company is legally bound to cede every policy that meets the treaty specifications, and the reinsurer is legally bound to accept every ceded risk without individual underwriting review.
• Operational Efficiency: Provides the direct insurer with automatic, seamless underwriting capacity. A direct underwriter can bind coverage for a client immediately, confident that reinsurance protection attaches automatically.
• Cost Effectiveness: Eliminates the administrative expense and underwriting delay of individual risk submissions.

3. Facultative-Obligatory (Fac/Oblig) Hybrid

A specialized hybrid mechanism combining elements of both forms:

• The ceding company has the option (freedom) to cede or withhold an individual risk.
• The reinsurer has the obligation to accept any risk ceded by the direct insurer, provided the risk falls within agreed underwriting parameters and monetary limits.
• It offers flexible surplus capacity without forcing the direct insurer to cede every risk in the class.

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Proportional Reinsurance Mechanics

In proportional (pro-rata) reinsurance, premiums and claims are shared between the cedant and the reinsurer in identical, predetermined mathematical proportions. The reinsurer receives an agreed percentage of the gross direct premium and pays the identical percentage of every claim, from the first dollar of loss.

To reimburse the direct insurer for marketing expenses, broker commissions, documentation costs, and MAS regulatory levies incurred in acquiring the business, the reinsurer pays the cedant a ceding commission (typically 20% to 35% of ceded premiums).

1. Quota Share Treaty

Under a Quota Share Treaty, the direct insurer cedes a fixed, predetermined percentage of every single policy written within the defined class, regardless of the sum insured.

• Reinsurer's Share of Risk = Sum Insured × Cession %
• Reinsurer's Share of Loss = Total Loss × Cession %

Worked Example: Quota Share Treaty

An insurer operates a 70% Quota Share Treaty on its commercial fire portfolio with a maximum policy limit of S$1,000,000. Ceding commission is 25%.

• The insurer underwrites a factory with a Sum Insured of S$500,000 at an annual Premium of S$4,000.
• Cedant Retention (30%):
  • Retains S$150,000 of the sum insured (S$500,000 × 30%).
  • Retains S$1,200 of the premium (S$4,000 × 30%).
• Reinsurer Cession (70%):
  • Assumes S$350,000 of the sum insured (S$500,000 × 70%).
  • Receives S$2,800 gross premium (S$4,000 × 70%).
  • Pays ceding commission of S$700 (S$2,800 × 25%) back to the cedant.
  • Net premium received by reinsurer: S$2,800 - S$700 = S$2,100.
• Claim Scenario: An electrical fire causes a loss of S$80,000.
  • Cedant pays S$24,000 (S$80,000 × 30%).
  • Reinsurer reimburses S$56,000 (S$80,000 × 70%).

Evaluation: Quota share is simple to administer and provides financing relief for new insurers. However, the direct insurer must cede away a fixed portion of small, highly profitable risks that it could comfortably retain.

2. Surplus Treaty

A Surplus Treaty introduces underwriting flexibility by allowing the cedant to retain 100% of smaller risks and cede only the surplus liability exceeding its net retention.

• The Line Concept: The cedant sets a monetary retention for its own account, known as "one line" or "own retention" (e.g., S$100,000).
• Capacity Calculation: The treaty capacity is expressed as a multiple of lines (e.g., a 5-line surplus treaty provides 5 lines × S$100,000 = S$500,000 in reinsurance capacity).
• Total Underwriting Capacity:
  • Total Capacity = Retention (1 Line) + Treaty (5 Lines) = 6 Lines = S$600,000

Worked Examples: Surplus Treaty Allocation

A direct insurer operates with a Retention of S$100,000 (1 line) and a 4-line Surplus Treaty (Treaty capacity = S$400,000; Total capacity = S$500,000).

• Case A: Small Risk (Sum Insured = S$80,000)

  • Because the sum insured is below the retention limit of S$100,000, the cedant retains 100% of the risk.
  • Cession to treaty: S$0 (0%).
  • Any loss is borne 100% by the direct insurer.

• Case B: Medium Risk (Sum Insured = S$300,000; Premium = S$3,000)

  • Cedant retains its maximum line: S$100,000 (1/3 or 33.33%).
  • Surplus ceded to treaty: S$200,000 (2 lines; 2/3 or 66.67%).
  • Premium allocation: Cedant retains S$1,000; Reinsurer receives S$2,000 (subject to ceding commission).
  • Loss Allocation (Claim = S$60,000):
    • Cedant pays: S$60,000 × 1/3 = S$20,000.
    • Reinsurer pays: S$60,000 × 2/3 = S$40,000.

• Case C: Maximum Risk (Sum Insured = S$500,000; Claim = S$250,000)

  • Cedant retains: S$100,000 (1/5 or 20%).
  • Surplus ceded: S$400,000 (4 lines; 4/5 or 80%).
  • On a S$250,000 claim: Cedant pays S$50,000 (20%); Reinsurer pays S$200,000 (80%).

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Non-Proportional (Excess of Loss) Reinsurance Mechanics

In non-proportional reinsurance, premiums and claims are not shared in fixed mathematical ratios. Instead, claims liability is allocated strictly according to the monetary severity (quantum) of the loss.

The ceding company retains and pays all losses up to an agreed threshold, termed the deductible, retention, priority, or attachment point. The reinsurer pays only the amount by which the loss exceeds the attachment point, up to an agreed maximum limit (the layer limit).

The reinsurance premium is not a pro-rata share of the original premium. Instead, the reinsurer charges an independent reinsurance premium calculated through actuarial pricing techniques (such as Rate on Line or burning cost).

1. Excess of Loss per Risk (Working XL)

Protects the direct insurer against large individual losses occurring on a single insured risk or policy (e.g., an unusually severe factory fire or commercial liability verdict).

• Reinsurer Payment Formula:
  • Reinsurer Payment = Min(Max(0, Loss - Attachment Point), Layer Limit)

Worked Example: Excess of Loss per Risk

An insurer purchases an Excess of Loss per Risk cover of S$400,000 in excess of S$100,000 (written as S$400,000 xs S$100,000):

• Attachment Point (Priority): S$100,000.
• Maximum Layer Limit: S$400,000 (covers losses between S$100,001 and S$500,000).
• Loss Outcome 1 (S$70,000 loss): Below attachment point. Cedant pays S$70,000; Reinsurer pays S$0.
• Loss Outcome 2 (S$350,000 loss):
  • Cedant pays its retention: S$100,000.
  • Reinsurer pays the excess: S$350,000 - S$100,000 = S$250,000.
• Loss Outcome 3 (S$650,000 loss):
  • Cedant pays its retention: S$100,000.
  • Reinsurer pays its full layer limit: S$400,000.
  • The remaining loss above S$500,000 (S$650,000 - S$500,000 = S$150,000) falls back onto the cedant as an uninsured excess (unless protected by a higher excess layer).
  • Total paid by cedant: S$100,000 + S$150,000 = S$250,000.

2. Excess of Loss per Event / Catastrophe (Cat XL)

Protects the cedant against the accumulation of multiple individual claims arising from a single catastrophic event (e.g., a tropical flash flood damaging hundreds of motor vehicles and retail basements in Orchard Road):

• Structure: Expressed per event (e.g., S$5,000,000 xs S$1,000,000 per catastrophe).
• Hours Clause: Catastrophe treaties incorporate an Hours Clause (e.g., 72 hours for windstorms or 168 hours for floods) defining the time window during which all related losses are legally deemed to constitute a single event.

3. Stop Loss / Aggregate Excess of Loss

Protects the cedant's entire underwriting portfolio against severe cumulative losses over an entire financial year:

• Loss Ratio Trigger: Instead of attaching to individual claims, it attaches when the cedant's annual aggregate loss ratio exceeds an agreed threshold (e.g., covering losses when the annual loss ratio exceeds 70% up to a ceiling of 100%).

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Comparison of Reinsurance Types