What is Cession
Cession refers to the portions of the obligations in an insurance company's policy portfolio that are transferred to a reinsurer. Risk can be transferred to the reinsurer in one of two ways: proportional or non-proportional. Proportional reinsurance is an arrangement where the insurer and reinsurer share an agreed percentage of both premiums and losses. Non-Proportional reinsurance is a system by which the reinsurer pays only when losses are over an agreed-upon amount.
BREAKING DOWN Cession
The reinsurance industry has become increasingly sophisticated due to competition within the insurance industry. Reinsurance creates an opportunity for insurer and reinsurers to profit at each others' expense, based on the accuracy of the actuarial calculations, which price the risk incurred. For example, suppose a reinsurer believes the risk of loss on a certain coverage is less than is actually the case. If an insurer has a more accurate risk model, he can recognize that a reinsurer is undercharging for this coverage. In this case, the insurer simply sells the policies to customers at the higher rate and buys reinsurance at the lower rate, locking in an arbitrage profit.
Why Insurance Companies Rely on Cession
Ceding a portion of risk to a reinsurer allows an insurance company to more effectively and efficiently manage its overall risk exposure. Reinsurance can be written by a specialist reinsurance company, such as Lloyd’s of London or Swiss Re, by another insurance company, or by an in-house reinsurance department. Some reinsurance can be handled internally, such as with automobile insurance, by diversifying the types of clients that are taken on. In other cases, such as liability insurance for a large international business, specialty reinsurers may be used because diversification is not possible.
The agreement between the ceding insurance company and reinsurance company will include comprehensive terms under which the cession is ceded. The contract outlines the precise conditions under which the reinsurance company will pay claims. There are two main types of reinsurance contracts: facultative and treaty. In a facultative reinsurance contract, the insurer passes one type of risk to the reinsurer, meaning that each type of risk that is passed to the reinsurer in exchange for a premium has to be negotiated individually. In a treaty reinsurance contract, the ceding company and accepting company agree on a broad set of insurance transactions that will be covered by reinsurance. For example, the ceding insurance company may cede all risks for flood damage and the accepting company may accept all risk for flood damage in a particular geographic area, such as a floodplain.