The other principle type of proportional reinsurance is called a surplus treaty. It can be best thought of as a variable quota share, see the previous post. The company that is being reinsured is called the ceding company. Remember, in a quota share treaty, the ceding company, usually a insurance company, agrees to give the reinsurers a fixed percentage of its premiums, less a commission, for part or all of its business in return for the reinsurers paying the same fixed percentage of the losses from that business. The percentage of premiums remains the same regardless of whether the risk being covered is a $50,000 cabin in the woods or a $600,000 home in suburbia.

An insurance company may feel that it can absorb smaller losses without too much of an impact on its balance sheet or P&L. It might also want a larger share of the premiums from smaller risks and a smaller share of losses from the larger risks. The surplus treaty is a way to achieve all these objectives.

With a surplus treaty, the ceding company keeps all the premiums and losses for risks that are valued at less than some fixed amount. This part of the concept is fairly easy to understand. It is the next part that sometimes throws a curve for people. When the risk is greater than this fixed amount, then all premiums and losses are shared in proportion that this fixed amount has to the total value of the risk.

I hope a couple of examples will clarify the sharing. We will examine three different risks, the $60,000 cabin, a $200,000 starter home and the $600,000 home. The fixed amount that we will use is $100,000. Since the cabin’s value is less than $100,000, the ceding company keeps all the premiums that it receives for insuring the cabin and pays all of the loss that it may have from that cabin.

The starter home is valued at twice the fixed amount, $200,000 vs. $100,000. Thus, the insurer’s share of the premiums and losses is 50%. It will give or cede 50% of the premiums and will recover 50% of all the losses associated with this house and not just those that are greater than the fixed amount of $100,000. In the last example, the insurer’s share is 1/6th of the premiums and losses and the reinsurers’ share is 5/6th , $600,000 vs. $100,000.