What is ceding?
Ceding means you give something away to someone else. In the world of insurance, ceding happens when one insurance company gives some of the risk it is covering to another insurance company. The company that is ceding the risk is called the insured or the ceding insurer. The company that takes on the risk is called the insurer or the reinsurer.
How ceding works
Here’s how ceding works. Let’s say there is an insurance company called Acme Insurance. Acme sells car insurance to lots of people. Each person pays some money called a premium to Acme. In exchange, Acme promises to pay for any car accidents those people have, up to a certain amount of money.
Acme likes getting those premium payments. But Acme is also a bit worried. What if a whole bunch of those people have really bad car accidents all at once? Acme might have to pay out a huge amount of money. It could be more money than Acme has!
Why insurers cede risk
This is where ceding comes in. Acme goes to another company, let’s call them Zenith Reinsurance. Acme says “Hey Zenith, I’ll pay you some money if you agree to pay for some of those car accidents if they happen.” Zenith thinks about it and says “Okay, it’s a deal.”
Now, if those bad accidents happen, Acme won’t have to pay for all of it. Zenith will pay for some of it. Acme has ceded some of the risk to Zenith. Acme feels better because it knows it won’t go broke if there are a lot of accidents. And Zenith is happy because it gets paid some money by Acme and hopefully won’t have to pay out too much for accidents.
The ceding contract
When Acme and Zenith make this deal, they write it all down in a contract. This contract is called an insurance contract or a reinsurance contract. The contract says exactly how much risk Acme is ceding to Zenith and how much Zenith will pay if the bad things happen.
Types of ceding contracts
There are a couple of different ways these contracts can work:
Proportional ceding
One way is called proportional ceding. In this type of contract, Acme and Zenith agree to split the premiums and the risk by a certain percentage. Let’s say they agree to a 70/30 split. This means Acme keeps 70% of the premiums and 70% of the risk. Zenith gets 30% of the premiums but also has to cover 30% of the risk.
Non-proportional ceding
The other main type is called non-proportional ceding. In this case, Acme keeps all of the premiums up to a certain amount, and Zenith doesn’t get any of that money. But if the claims go above that amount, Zenith has to pay for everything over that amount.
For example, let’s say Acme and Zenith agree that Acme will pay for all claims up to $1 million. If the claims are less than $1 million, Zenith doesn’t pay anything. But if the claims go over $1 million, Zenith has to pay for everything over that $1 million mark.
Why is ceding important?
Ceding is super important in the insurance world. If insurance companies couldn’t cede risk, many of them would be in big trouble. They might not be able to insure as many people or things because they would be worried about having to pay out too much money.
Ceding spreads the risk around
By ceding risk to other companies, insurance companies can spread that risk around. No single company has to worry about huge disasters wiping them out. The risk is shared among multiple companies.
This is especially important for really big risks, like hurricanes or earthquakes. A single insurance company probably can’t handle that all on its own. But if a bunch of insurance companies share the risk through ceding, it’s not as scary for each individual company.
Ceding helps insurers grow
Ceding also allows insurance companies to insure more people and businesses than they could otherwise. If an insurance company had to keep all the risk for itself, it would have to be really careful about how many policies it sold. It wouldn’t want to have too much risk.
But if the company can cede some of that risk to other companies, it can feel more comfortable selling more policies. It knows it has some backup if things go wrong. This allows insurance companies to grow and insure more clients.
The downsides of ceding
Ceding isn’t perfect though. There are some potential downsides and risks to ceding.
Dependence on reinsurers
One issue is that the insurance company is now dependent on the reinsurance company. If the reinsurance company goes out of business or refuses to pay, the insurance company could be in a tough spot. It was counting on that reinsurance money and now it might not get it.
Complex contracts
The ceding contracts can also be pretty complex. There are a lot of details to work out, like exactly how much risk is being ceded, how the premiums will be split, and what happens in various situations. If there are misunderstandings or disagreements about the contract, it can lead to problems down the road.
Reduced profits
Ceding also means the insurance company is giving up some of its profits. It has to pay the reinsurance company for taking on that risk. If there aren’t many claims, the insurance company might feel like it could have kept more of the money for itself instead of giving it to the reinsurance company.
