When I began working in reinsurance 40 years ago, proportional treaty reinsurance was far more widespread than it is today and in fact formed the backbone of the reinsurance broker’s business. While excess of loss contracts were routinely placed, it was not until the mid-1980s that they began to become a broker’s principal source of revenue.
That is not to say that proportional treaties died out; far from it. They remain a vitally important component of an insurer’s strategy to boost capacity and stabilise underwriting results. However, there was a growing tendency to place such contracts directly between the reinsured and the reinsurer.
The increasing focus by brokers on excess of loss contracts could lead to an increasing knowledge deficit when it comes to the operation of proportional treaties. Such knowledge is vital if we are to deliver a professional service to our clients, as a properly constructed reinsurance programme is often a blend of proportional and non-proportional contracts.
I have discussed treaty structures in previous blogs, so I now want to get into some of the more complex technical aspects and hopefully demystify some of the terminology. The theme of today’s blog is the operation of the PERIOD provision.
Contract Period vs. Original Policy Periods
Most proportional treaty contracts are continuous, meaning that once established, they carry on indefinitely until one of the parties signals their intention to cancel. For the sake of convenience “normal” cancellation (not enforced by war, insolvency etc) can only take place on a given date each year, which is known as the anniversary date of the contract. The period between consecutive anniversary dates is known as an underwriting year.
For example, many contracts have an anniversary date of 31st December, meaning that each underwriting year runs from 1st January to 31st December. Unfortunately, the people who purchase the original insurance policies that the insurer cedes to the treaties do not all arrange those policies to run for exactly a year from 1st January. The original policies will start on various dates throughout the year, which means that when the underwriting year comes to an end, some of the policies will still be running and be capable of producing claims.
That would not be so much of a problem if the treaty were truly continuous, i.e., that the relationship between the Reinsured and the Reinsurer were fixed from day one and carried on for all eternity. But things don’t happen that way in real life. Reinsurers come and go and often their shares in the contract alter from year to year. We need some way to allocate premium and claims transactions to the correct reinsurers and for the correct shares. There are two basic methods for achieving this, known as underwriting year basis and annual clean-cut basis.
The traditional way of operating a proportional treaty is on an underwriting year basis. Think of a treaty that runs from 1st January to 31st December each year. All policies that incept (start) or are renewed between those two dates will attach to the underwriting year in which the policy incepted. Every transaction (premium or claim payment) on all of those policies will belong to the underwriting year in which the policy incepted.
For example, if a policy commences on 1st February 2013, any premiums or claims processed in relation to that policy will be due to or from the reinsurers of the 2013 underwriting year. A claim might occur on the last day of January 2014 and might not be settled for another 6 months. Nevertheless, that claim will be payable by the 2013 reinsurers. This is what we mean when we say that a contract has a tail. The treaty year ends on 31st December 2013, but the reinsurers’ exposure continues beyond that date.
Many treaties are arranged in precisely that way and in most cases, due to the technicalities of the business (as I’ll explain later), cannot be managed in any other way.
Proportional treaties are a great way of boosting an insurer’s automatic acceptance capacity, but a further advantage is the way the insurer processes the financial transactions to the reinsurer. The insurer issues regular accounts to the reinsurer, commonly quarterly, comprising the premium and claims movements of perhaps thousands of individual policies.
In that way, the insurer just needs to settle the overall balance with its reinsurer(s) once every quarter. However, where the treaties operate on an underwriting year basis, there might not be just one account per quarter, but one for each underwriting year where there are outstanding transactions on any of the ceded policies.
Wouldn’t it be great if we only had to process one account per quarter? How could we do that? There are two things we must consider. Firstly, at the anniversary date of the treaty, can we calculate a fair amount of unexpired premium that we can take away from the outgoing reinsurers and give to the new reinsurers? If we can do that, we can effectively cancel every policy at midnight on 31st December and purchase the same amount of reinsurance from a new set of reinsurers from 1st January.
Any losses affecting those policies that happen on or after 1st January will then be the responsibility of those new reinsurers. Secondly, are there any losses that had occurred before 31st December that have not yet been paid (outstanding losses)? If we can accurately estimate the amount of outstanding losses due from the outgoing reinsurers, we can ask them to pay that amount immediately and pass the money to the new reinsurers, who will then become responsible for paying the claims when they are eventually settled.
If we can perform these two operations at the beginning and end of each underwriting year, the treaty becomes clean-cut. The reinsurers of the current year are responsible for all financial movements that occur during the year, including those that relate to policies that started in the previous year.
However, those reinsurers have certainty that they will not be responsible for any transactions that take place after the end of the year. The two operations are called Premium Portfolio Transfer and Outstanding Loss Portfolio Transfer. At the beginning of the year, the reinsurers receive a statement of Incoming Portfolio Transfer and at the end of the year they receive a statement of Outgoing Portfolio Transfer.
When can Clean-cut Accounting be Used?
A clean-cut system can only be adopted when it is possible to calculate with reasonable accuracy the amount of unexpired premium that needs to be passed on to next year’s reinsurers. Some classes of business have policy periods that vary considerably from a few months to several years. Contractors’ All Risks business is a prime example of this. What is more, the construction contracts have different phases, such as demolition, ground works etc, all of which have different degrees of hazard throughout the policy period.
It would be practically impossible to calculate the unexpired premiums with any degree of accuracy. Marine Cargo policies cover goods in transit from the supplier to the customer. The policy covers the voyage itself, rather than any specific time period, so again, it is impossible to apportion the premium over two treaty years. Another example is Bond or Credit business, where although the policy periods could be annual, there is usually very little chance of a loss coming to light until the covered payment becomes due (the entire risk is effectively on the last day of the policy).
For these reasons, clean-cut treaties tend to be restricted to Fire and Allied Perils, Personal Accident, Renewable Engineering and any other classes where the policy periods are mostly annual and the level of risk is evenly distributed throughout the policy period.
There are several methods of calculating the unexpired premium element of a portfolio transfer, which I shall explore in a future blog.
This post was originally published July 25, 2013.