What is 'Obligatory Reinsurance'

Obligatory reinsurance is reinsurance in which the ceding insurer agrees to send a reinsurer all policies which fit within the guidelines of the reinsurance agreement. An obligatory reinsurance treaty, also called an automatic treaty, requires the reinsurer to accept these policies.

BREAKING DOWN 'Obligatory Reinsurance'

Obligatory reinsurance is a type of treaty reinsurance in which an insurer is required to cede and a reinsurer required to accept all risks that meet a set of predetermined conditions. This allows the insurer and reinsurer to develop a long-term relationship, as the insurer does not have to find a new reinsurer for every new risk. Each risk is automatically accepted under the terms of the arrangement, even if the insurer has yet to notify the reinsurer.

Because obligatory reinsurance features automatic acceptance, both the insurer and reinsurer need to be certain that the terms of the agreement include an accurate description of the type of risks that the treaty covers. This is an important step in removing ambiguities that, if left unaddressed, may require the arrangement to be canceled. If the ambiguities are discovered too late, it may be difficult to unwind the arrangement since risks may have already been exchanged.

Automatic acceptance also increases the risk of insolvency. Each party will want to make sure that the other is being managed properly, and that the interests of the ceding insurer align with those of the reinsurer.

Types of Reinsurance

Facultative coverage protects an insurer for an individual or a specified risk or contract. If several risks or contracts need reinsurance, each is negotiated separately. The reinsurer has all rights for accepting or denying a facultative reinsurance proposal. Treaty reinsurance, meanwhile, is effective for a set time period rather than on a per-risk or contract basis. The reinsurer covers all or a portion of the risks that the insurer may incur. Both of these types of reinsurance may be classified as obligatory if the reinsurance contract mandates all policies that fall within the scope of the contract are transferred.

By contrast, an obligatory-style contract isn't available for some types of reinsurance. Those types of reinsurance include proportional reinsurance and non-proportional reinsurance. Proportional reinsurance is where the reinsurer receives a prorated share of all policy premiums sold by the insurer. When claims are made, the reinsurer bears a portion of the losses based on a pre-negotiated percentage. The reinsurer also reimburses the insurer for processing, business acquisition, and writing costs. With non-proportional reinsurance, the reinsurer is liable if the insurer's losses exceed a specified amount, known as the priority or retention limit. As a result, the reinsurer does not have a proportional share in the insurer's premiums and losses. The priority or retention limit may be based on one type of risk or an entire risk category.

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