Profit Commission in Proportional Treaties

Accounting

Proportional reinsurance treaties can be quite complicated animals when it comes to handling their financial aspects.  While the processing of the accounts is now largely a mechanical process, understanding what they actually mean is far harder.  A case in point is the profit commission (PC) statement.

On the face of it, a PC is quite simple; it rewards the Reinsured for successfully creating a profit for the reinsurers by rebating an agreed percentage of the profit the treaty has generated during the year.

“Profit” is the amount by which the income exceeds the outgo, so what could be simpler?  Let’s look at a typical PC formula and explore some of the difficulties.

Income

  • Premium ceded during the year
  • Premium Reserve brought forward from the previous year OR
  • Incoming Premium Portfolio Transfer from the previous year
  • Outstanding Loss Reserve brought forward from the previous year OR
  • Incoming Loss Portfolio Transfer from the previous year

Outgo

  • Commission and taxes deducted from ceded premium
  • Paid losses during the year
  • Reinsurers’ (or Management) Expenses at an agreed percentage of the premium item
  • Premium Reserve at the end of the period OR
  • Outgoing Premium Portfolio Transfer to the following year
  • Outstanding Loss Reserve at the end of the period OR
  • Outgoing Loss Portfolio Transfer to the following  year
  • Any deficit from prior years’ calculations (may be time-limited or until extinction)

Already we can see the potential complications.  Intuitively, you might think the profit is simply the accumulated balances received by the reinsurers during the year.  That might simply be the premium, less the commission, tax and claims.

But as we saw in a previous blog, we need to deal with the fact that individual policies ceded to the treaty may still be running when the PC calculation is made and there are bound to be outstanding claims that may take months or even years to settle.

The items I have shown here allow for the fact that some treaties deal with the issue of unexpired liabilities by transferring them into the next year, resulting in a “clean-cut” treaty, while others (the majority, in fact) leave the treaty’s underwriting year open until all liabilities for policies attaching to it have been settled.

Whether the treaty operates on an underwriting year or clean-cut basis has major ramifications for how the PC statement is constructed.  But before we go into that question, there are a couple of items under Outgo that I want to talk about.

A Few Points to Consider

The first item is frequently referred to as “Management Expenses” and is a flat percentage of the ceded premium.  The purpose of this item gives rise to plenty of debate between brokers and reinsurers.  If you look at the accounts statements the reinsured sends to the broker or the reinsurers every quarter, you will not find Management Expenses anywhere.

I always explain this as an artificial item of outgo that allows the reinsurer a level of pure profit, before PC has to be paid.  That’s probably an over-simplification.  Let’s consider what happens when a broker receives a statement for the Reinsured.  He has to process it to the reinsurers and in doing so, will deduct his brokerage (generally 2.5% of the ceded premium).

That brokerage does not form a part of the contract between the Reinsured and his reinsurers; it is a fee the reinsurers pay to the broker for introducing the business.  In effect, the brokerage is one of the invisible costs to the reinsurer.

Invisible Costs

It is those invisible costs that the Management Expenses item takes out, so that the reinsurers are not paying PC on profit they have not actually received.  Anyone who has ever asked why brokerage has not been included in the PC calculation should now understand the answer.

The second item deals with the question of the carry-forward of deficits from previous years.  Contracts will specify for how many years any deficits may be carried forward.  The most common examples are 3, 5 or to extinction.

What Does That Mean?

Basically, if the total income minus the total outgo results in a negative figure, that figure will be carried forward to the profit commission calculation of the next underwriting year (note: not the next calculation that adjusts the current year) PC.  The deficit will be carried forward for the next 3 or 5 underwriting years, or until it is cancelled out by subsequent profitable years, whichever happens first.

To extinction means that the deficit will keep rolling forward into subsequent underwriting years until the income is once again greater than the outgo.  If the deficit carry-forward has a time-limit, it will be wise to keep the deficit out of the main calculation and take it off the balance at the end, in order to be sure that we shall stop counting a deficit after its carry-forward period has expired.

The carry-forward provisions introduce a particular area of difficulty to treaties that are not clean-cut.  In a situation where Underwriting Year (UY) 1 produces a deficit at the end of Accounting Year (AY) 2, the deficit must be deducted from any profit form UY2, AY1.

Of course, even after AY2, the final result of UY1 may not be certain, because there could still be claims outstanding.  When we come to the end of AY3 of UY1, the deficit might have changed, which will have a knock-on effect into the AY2 calculation of UY2 and possibly AY1 of UY3.

Life would of course be far easier if all treaties were clean-cut; then we would only need accounts for the portfolio entry, a year’s worth of accounts (e.g., 4 quarterly accounts), a portfolio withdrawal and a PC.

Unfortunately, clean-cut treaties are only commonplace for classes of business where the overwhelming majority of the policies are annual and the losses are notified quite soon after they have occurred, which rules out many classes, such as Contractors’ All Risks, Marine, Liability etc.

Finally, I should add that the items for premium reserve and outstanding loss reserves will exist for underwriting year contracts, irrespective of whether or not the treaty allows for such reserves to be withheld in account.

At the end of year one of the treaty, much of the premium will still be unearned, and so it stands to reason that reinsurers will not pay profit commission on premium that is not fully earned.  For that reason you will frequently find that for Contractors’ All Risk business, the first PC calculation takes place at the end of AY3 for each underwriting year.

About Keith Riley

Keith Riley is Divisional Director in Willis Re's Asia Pacific, Middle East, Turkey and Africa team. Keith’s rein…
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