# Understanding Treaty Reinsurance: Definition, Mechanism, and Contract Types

## What Is Treaty Reinsurance?

In treaty reinsurance, an insurer (the cedent) transfers the risks of a specific class of policies to a reinsurer through a contract. This arrangement mitigates the insurer's exposure to risk while enhancing stability and security in the face of major events. By offloading risk, insurers gain the freedom to underwrite more policies without heightened solvency concerns.

### Key Takeaways

*   Treaty reinsurance allows an insurance company to transfer risks of a specified class of policies to another insurer, known as the reinsurer.
*   There are two main types of treaty reinsurance contracts: proportional, where risks and premiums are shared, and non-proportional, which involves payouts above a set threshold.
*   Unlike facultative reinsurance, treaty reinsurance covers a block of risks under a single contract without individual negotiations.
*   Treaty reinsurance provides ceding insurers with enhanced stability and security, particularly during major or unusual events.
*   Excess of loss reinsurance is a non-proportional form distinct from both treaty and facultative reinsurance, as it involves sharing losses beyond certain limits.

## How Treaty Reinsurance Works

Treaty reinsurance is a contract where the ceding insurance company transfers risks to the reinsurer for a set period.

When insurance companies [underwrite](https://www.investopedia.com/terms/u/underwriting.asp) a new policy, they agree to take on additional risk in exchange for a [premium](https://www.investopedia.com/terms/i/insurance-premium.asp). The more policies an insurer underwrites, the more risk it assumes. One way an insurer can reduce its exposure is to cede some of the risk to a reinsurance company in exchange for a fee. Reinsurance allows the insurer to free up risk capacity and to protect itself from high severity claims.

Even though the reinsurer may not immediately underwrite each individual policy, it still agrees to cover all the risks in a treaty reinsurance contract.

By signing a treaty reinsurance contract, the reinsurer and the ceding insurance company indicate that the business relationship will likely be long-term. The long-term nature of the agreement enables the reinsurer to plan for a profit, as it is aware of the type of risk it is taking on and is familiar with the [ceding company](https://www.investopedia.com/terms/c/ceding-company.asp).

Treaty reinsurance contracts are either proportional or non-proportional. In proportional contracts, the reinsurer assumes a set percentage of policies and receives the same share of premiums. If a claim is filed, it will pay the stated percentage as well. In non-proportional contracts, the reinsurer pays claims exceeding a set amount within a specific time.

## Benefits of Treaty Reinsurance for Insurers

Treaty reinsurance provides the ceding insurer with increased equity security and stability during major or unusual events.

Reinsurance helps insurers underwrite more risk without significantly increasing the costs of meeting solvency margins. In fact, reinsurance makes substantial liquid assets available for insurers in case of exceptional losses.

## Comparing Treaty, Facultative, and Excess of Loss Reinsurance

Treaty reinsurance differs from [facultative reinsurance](https://www.investopedia.com/terms/f/facultative-reinsurance.asp). Treaty reinsurance involves a single contract covering a type of risk and does not require the reinsurer to provide a facultative certificate each time a risk is transferred from the insurer to the reinsurer.

Facultative risk, on the other hand, allows the reinsurer to accept or reject individual risks. Moreover, it is a type of reinsurance for a single or a specific package of risks. That means both the reinsurer and the cedent agree on what risks will be covered in the agreement. These agreements are generally negotiated separately for each policy.

The expenses involved in underwriting facultative contracts are thus much more expensive than a treaty reinsurance agreement. Treaty reinsurance is less transactional and less likely to involve risks that would have otherwise been rejected from reinsurance treaties.

[Excess of loss reinsurance](https://www.investopedia.com/terms/e/excess-loss-reinsurance.asp) is a type of non-proportional reinsurance. In an excess of loss contract, the reinsurer agrees to pay the total amount of losses or a certain percentage of losses above a certain limit to the cedent. Excess of loss reinsurance is less similar to standard insurance, like treaty and facultative reinsurance are, often requiring both the cedent and reinsurer to share in the losses.

## The Bottom Line

Treaty reinsurance is a crucial financial strategy that provides insurance companies with a safeguard against a range of risks. By forming long-term contracts with reinsurers, ceding companies can secure more stability and free up risk capacity. The two primary forms of treaty reinsurance, proportional and non-proportional, offer different mechanisms to manage exposure. Understanding these options allows insurers to effectively protect their portfolios, particularly against high-severity claims, without increasing solvency costs excessively. In contrast to facultative and excess of loss reinsurance, treaty reinsurance provides comprehensive coverage for a class of risks via a single agreement, minimizing transactional complexities.