Cession

What Is Cession?

Cession refers to the transfer of part of an insurance company's obligations to a reinsurer. This allows the ceding company to reduce its exposure, so that risk is distributed among two or more companies instead of falling upon a single insurer.

Insurance can be ceded in 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 exceed an agreed-upon amount.

How Cession Works

Insurance companies make money by assuming the risks of certain unlikely events, such as fires, accidents, or floods, in exchange for a premium that is higher than the expected payout. When an insurer assumes new risks, they must ensure that the maximum payout will not bankrupt the insurance company.

Cession allows an insurer to reduce their risks by passing on some of them to the reinsurance market, as well as a portion of the profits. In short, the insurers are taking out an insurance policy of their own, to protect themselves against the possibility of having to make a large payout.

Reinsurance creates an opportunity for insurers and reinsurers to profit at each others' expense, based on actuarial calculations that 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 a higher rate and buys reinsurance at the lower rate, locking in an arbitrage profit.

Reinsurance

Ceding risk to a reinsurer allows an insurance company to reduce 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 the reinsurance company will include comprehensive terms for the cession. The reinsurance contract will outline 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 the 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 risks for flood damage in a particular geographic area, such as a floodplain.

Benefits of Cession

Cession allows insurers to provide coverage against events that they would otherwise be unable to handle, due to the possible size of the payout. If a certain type of accident has an extremely low probability, but an extremely high payout, a single insurance company might not be able to underwrite a policy, even at a relatively high premium.

Reinsurance allows insurers to provide coverage by passing on some of the risks to another insurer, as well as a share of the premiums. This works to the benefit of all involved: both the insurer and the reinsurer can expect a net profit, while the insured is able to receive the coverage they need to do business.

Example of Cession

An interesting example of cession appears in nuclear insurance pools, which provide coverage for nuclear power plants. In the United States, plant operators pay annual premiums of more than $1 million per reactor. Although accidents are extremely rare, a single serious event could cause billions of dollars in liability—much more than a single insurer could handle.

As a result, many countries have nuclear insurance pools that provide coverage against such an eventuality, diffusing risk among many plant operators. In the United States, the nuclear insurance pool can cover up to $13 billion of losses.

But even that amount might not be able to cover a truly catastrophic accident. For this reason, many nuclear pools provide reinsurance to one another, thereby sharing some of their risks and premiums. Since it is extremely unlikely for two catastrophic events to happen at the same time, these arrangements allow nuclear operators to obtain insurance protection that would otherwise be difficult to obtain.