Ceding Commission: Definition, Purpose, Calculation Formulas

Ceding Commission

Investopedia / Ryan Oakley

What Is a Ceding Commission?

A ceding commission is a fee paid by a reinsurance company to a ceding company to cover administrative costs, underwriting, and business acquisition expenses. The commission also helps the ceding company offset loss reserve premium funds.

Reinsurance is a method for insurers to spread the risk of underwriting policies by ceding some of their insurance policies to other, usually smaller, companies. Large companies will use reinsurers to reduce risk values on their books and allow themselves to acquire additional contracts.

The reinsurer will collect premium payments from policyholders and return a portion of the premium to the ceding company along with the ceding commission. The ceding company may pass part or all of its risks from its insurance policy portfolio to a reinsurance firm.

Key Takeaways

  • A ceding commission is a fee a reinsurance company pays to a ceding company for administrative, underwriting, and business acquisition expenses.
  • Reinsurers collect premium payments from policyholders and give a portion to a ceding company, along with a ceding commission.
  • A ceding commission is determined by either the use of a proportional treaty, also called a pro-rata treaty, or a quota share agreement.
  • Ceding commissions are included in the combined ratio, helping insurance companies determine if a reinsurance treaty will be profitable.

Understanding a Ceding Commission

Insurance companies looking to reduce risk exposure through the use of reinsurance often enter into a proportional treaty, also known as a pro-rata treaty. In a proportional agreement, both the ceding company and the reinsurer share in both the premium payment and in covering any claim losses based on an agreed-upon percentage. As an example, a ceding insurer may retain 60% of the premium and risk while ceding 40% away.

Alternatively, the insurer may use a quota share agreement. With this method, the reinsurer agrees to assume a fixed percentage of the possible claims loss before the ceding company becomes liable. In this example, the ceding company uses a 60% quota share and keeps only 40% of paid premiums and covers only 40% of a claim. The reinsurer receives 60% of the premium and must cover 60% of all damages. Most quota share agreements will include a maximum dollar amount of damage that the reinsurer is responsible for covering.

Calculation of a Ceding Commission

Ceding commissions are part of the reinsurance treaty and usually stated as a percentage. The contract will also include effective dates where the agreement may renew or be restructured. The charging of commission helps the ceding insurer offset some of the cost it incurred in underwriting the policy. Further, the ceding commission helps compensate for lost premium funds the ceding company would have held in reserve for the necessity of covering a claim.

Reinsurance treaties may also calculate the ceding commission on a sliding scale linked to the actual loss events. This arrangement typically includes a maximum and minimum commission rate. The sliding commission fee will decrease as the loss ratio increases.

Ceding Commission and Company Profits

Insurance companies base decisions and profitability on the combined ratio. This figure is the total of all losses and expenses to underwrite a policy divided by the earned premiums. This ratio helps a company estimate if a particular reinsurance treaty is profitable. Expenses include general overhead, brokerage fees, ceding commissions, and other costs.

Actuaries will look at the combined ratio and use it to determine whether the terms of the reinsurance agreement will provide an acceptable return.