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.
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.
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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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