As with many things in this world, reinsurance has many variations. Fundamentally, there are just two types of reinsurance, proportional or excess. The way in which reinsurance is bought is either for a broad range risks which is called treaty reinsurance or for an individual risk which is called facultative reinsurance. Many insurance companies will buy both treaty and facultative reinsurance and sometimes it will be on the same risk. We will leave explanations of the variations for another day. For now, let’s just explore proportional reinsurance.

An insurance company may not want to keep all of a line of business on its own books. For example, it may have introduced a new product and it is writing a lot of business. The premium income is great but it might put some strains on its capital. At this point the company has three choices. First, it can stop writing new business. Most companies wouldn’t want to put the breaks on a hot new product. Second, they could try to raise new capital. This option is not always available and the additional capital stays around even if the product does not. The third choice is a quota share reinsurance treaty which can be cancelled if the product dies down or capital increases without any penalty.

The most basic type of proportional or pro rata reinsurance is called quota share reinsurance. It is also the easiest to understand. In return for accepting a fixed percentage of premiums for this line of business, the reinsurer agrees to pay for the same fixed percentage of losses. The premiums that the insurance company sends to the reinsurer are called ceded premiums. The insurance company has certain expenses associated with this business such as agents commissions, taxes or internal expenses. The reinsurer will compensate the insurer for these expenses by giving a commission on the ceded premiums that it receives. It is called a ceding commission.