Both Treaty and Facultative reinsurance can be underwritten on a proportional (or quota share) basis, a non-proportional (excess of loss) basis or on a stop-loss basis.
With respect to Proportional or quota share reinsurance, the reinsurer, in return for a predetermined portion or share of the insurance premium charged by the ceding company, indemnifies the ceding company against the same predetermined portion or share of the losses of the ceding company under the covered insurance contract or contracts. In the case of reinsurance written on a non-proportional, excess of loss or excess of stop-loss basis, the reinsurer indemnifies the ceding company against all or a specified portion of losses, on a claim by claim basis or with respect to a specific event or line of business, in excess of a specified amount, known as the ceding company’s retention or reinsurer’s attachment point, and up to a negotiated reinsurance treaty limit.
Although the losses under a quota share reinsurance treaty are greater in number than under an excess of loss contract, it is generally simpler to predict these losses on a quota share basis and the terms and conditions of the contract can be drafted to limit the total coverage offered under the contract. A quota share reinsurance treaty does not, therefore, necessarily require that a reinsurance company assume greater risk exposure than on an excess of loss contract. In addition, the predictability of the loss experience may better enable underwriters and actuaries to price such business accurately in light of the risk assumed, thereby reducing the volatility of results.
Excess of loss reinsurance is often written in layers. One or a group of reinsurers accepts the risk just above the ceding company’s retention up to a specified amount, at which point another reinsurer or a group of reinsurers accepts the excess liability up to a higher specified amount or such liability reverts to the ceding company. The reinsurer taking on the risk just above the ceding company’s retention layer is said to write working layer or low layer excess of loss reinsurance. A loss that reaches just beyond the ceding company’s retention will create a loss for the lower layer reinsurer, but not for the reinsurers on the higher layers. Loss activity in lower layer reinsurance tends to be more predictable than that in higher layers due to a greater historical frequency, and therefore, like quota share reinsurance, enables underwriters and actuaries to more accurately price the underlying risks involved.
Premiums payable by the ceding company to a reinsurer for excess of loss reinsurance are not directly proportional to the premiums that the ceding company receives, because the reinsurer does not assume a directly proportionate risk. By contrast, premiums paid by the ceding company to the reinsurer under a quota share contract are strictly proportional to the premiums received by the ceding company, and correspond to its share of the risk coverage. In addition, in a quota share reinsurance treaty, the reinsurer generally pays the ceding company a ceding commission. The ceding commission is usually based on the cost for the ceding company of acquiring the business being reinsured (commissions, premium taxes, assessments and miscellaneous administrative expense) and may also include a profit ratio.