What are ceded premiums?
Ceded premiums are money that an insurance company pays to another insurance company. The other company is called a reinsurer. The reinsurer takes on some of the risk from the first insurance company. Reinsurance helps spread out risk among many companies.
Why insurance companies use ceded premiums
Insurance is a business where companies take on risk for people and businesses. They get paid premiums and hope that what they pay out in claims is less than what they collect.
Insurance works because the premiums of many are used to pay the claims of a few. But sometimes an insurance company takes on a risk that is too big for it to handle alone. Think about covering the Empire State Building. That’s a huge risk for one company.
Buying reinsurance to share risk
The insurance company could buy reinsurance. It would pay part of the premiums it collects to the reinsurer. The reinsurer would then pay out a share of any claims. The premiums paid to the reinsurer are the “ceded premiums”. Ceding means giving up or transferring.
The insurance company “cedes” part of the premiums and part of the risk to the reinsurer. Now the risk is shared between two companies. The first company pays ceded premiums but has less risk. The reinsurer gets premiums and takes on risk.
Types of reinsurance with ceded premiums
There are two main types of reinsurance. Both use ceded premiums but they work a bit differently.
Treaty reinsurance
In treaty reinsurance, the insurance company and reinsurer make a deal to share premiums and claims on a whole book of business. The deal could be for a share of all car insurance policies or for all policies over a certain amount.
Treaty reinsurance is convenient. The insurance company automatically cedes a share of premiums and risk to the reinsurer for the type of policies in the treaty. But it may cede more than it needs to.
Facultative reinsurance
Facultative reinsurance works policy by policy. The insurance company picks a particular policy it wants reinsurance on. It asks reinsurers to bid on taking a share of that one policy.
The reinsurer looks at the policy and decides whether to take it and at what price. If the insurance company likes the deal, it cedes the agreed premium to the reinsurer.
Facultative takes more work. But the insurance company only cedes premiums and risk where it feels it needs to. This can mean less ceded premium and more profit.
How ceded premiums are calculated
The ceded premium has to be enough to get the reinsurer to take on the risk. But not so much that the insurance company loses money. Calculating the right ceded premium takes some work.
Sharing premiums and risk
The simplest method is a straight share of the premium. The reinsurer takes a set percentage of the premium and risk. If the share is 40%, the ceded premium is 40% of the premium the insurer collected from the customer.
But the reinsurer doesn’t have the up front costs that the insurer did in making the sale. It doesn’t need 40% of the premium to make a fair profit. The insurer wants to keep as much premium as it can.
Ceding commissions
The solution is often a ceding commission paid back to the insurer. Say the agreed ceding commission is 35%. The reinsurer takes 40% of the risk but gives back 35% of that as a ceding commission.
The insurer gets to keep 35% of the ceded premium. So if the premium was $1000, the ceded premium would be $400 (40%) but the insurer gets back $140 (35% of the ceded premium). The reinsurer keeps $260 in premium and takes a 40% share of the risk.
This ceding commission compensates the insurance company for the cost of getting the customer and doing the paperwork. The ceding commission can vary a lot. It will depend on things like:
- The type of insurance
- How much profit there is likely to be
- The market price for reinsurance
- How much the insurer and reinsurer want the business
Ceding commissions of 20-30% are common. But some can be 50% or more on very profitable business that reinsurers really want.
The benefits of ceded premiums
Ceded premiums have some big benefits for both insurance companies and reinsurers.
Insurance companies
The key benefit of ceded premiums for insurance companies is reducing risk. Every premium they cede is risk moved to someone else’s balance sheet.
This lets an insurer write bigger policies and not put too much risk in one place. Think of an insurer that usually writes policies with $1 million limits. It might not want one for $10 million.
But it could write the $10 million policy if it could cede 90% of the premiums and risk to reinsurers. The insurer shares the premiums but sticks to its $1 million risk limit.
Ceded premiums also let insurers write more policies. Every company has a limit on how much total risk its balance sheet can handle. Ceded premiums let the insurer write more total premium and risk but keep its net risk down to the right level.
Reinsurance companies
The benefit of ceded premiums for reinsurance companies is profit and diversification. Reinsurers need premium coming in to invest and to pay claims. Ceded premiums give them premium without the costs of selling policies.
Reinsurers make money in two ways. They make an underwriting profit if premiums are more than claims plus expenses. And they make money investing the premiums until claims have to be paid out. The combined ratio is the key measure of how well the reinsurer is doing.
A reinsurer also gets diversification through ceded premiums. It can take small shares of many risks and not have all its eggs in one basket. Ceding also lets reinsurers access business all over the world and not just where they have sales offices.
