Reinsurance refers to the purchase of insurance by an insurance company from a different insurance company. The company who bought the insurance is called the insurer or the ceding company, while the company to which the insurance is bought is referred to as the reinsurer or the cedent. Reinsurance is done for the purpose of shifting insurance risks such as liability for losses. In this case, the ceding company is not obliged to pay losses obtained in the course of business since the cedent remains accountable to insurance policyholders. Thus, all losses are still shouldered by the cedent or reinsurer. In return, the reinsurer shall receive reinsurance premiums from the ceding company for indemnification. Reinsurance premiums are however deducted of ceding commissions. Ceding commissions include costs of acquisition, licenses, taxes, overhead expenses, and certain fees in place of expected profit shares.
Reinsurance is of two methods, facultative and treaty reinsurance. Facultative reinsurance shows a scenario where the reinsurer bears all or a portion of a risk that has been assumed by a particular insurance policy; while treaty reinsurance, as the name depicts, requires the reinsurer and the ceding company to create an accurate reinsurance contract. In treaty reinsurance, two methods are employed: the quota share, and the excess of loss. The excess of loss method is most widely used nowadays in the casualty and property insurance areas.
Given that certain risks are assigned to reinsurers in reinsurance, ceding companies can distribute higher limit policies. Thus, ceding companies are allowed to assume higher risks. But extreme employment of reinsurance may signal a company to have financial difficulties. Indeed, research shows that companies that use reinsurance more often are those that are less solvent, since it has no ability to create the capital it needs in the organized financial market. In turn, the present reinsurance market has become stricter and more complex. This is due to the considerable losses and financial impairments suffered by several reinsurers. Hence, since the year 2000, reinsurers have employed tedious reviewing, examining, and checking on the status of the companies they will reinsure.
The amount of insurance and other risks transmitted by the ceding company to the reinsurer is called the reinsurance ceded. This is accomplished in exchange for the affirmed reinsurance premiums. For example, a ceding company ceded $5,000,000 out of its $10,000,000 liability policy to a reinsurer in trade for a premium. The $5,000,000 here is the amount of reinsurance ceded. However, reinsurance companies may opt to limit the amount it will insure, and ceding companies are required to comply with such specifications, otherwise cannot acquire reinsurance.
Ceding commissions in reinsurance are included in the company’s income pro-rated over the risk’s overall period. The earned portion of the commissions will then be deferred and stated as a decrease in the costs of acquisition. The consolidated income statements accompanying it shall indicate premiums, losses, and adjustments expenses to loss, and acquisition costs, net already of the reinsurance ceded.
On the other hand, unearned ceded premiums will be reflected as prepaid premiums for reinsurance. The estimated recoverable of the reinsurance on losses unpaid are displayed as losses unpaid, and recoverable adjustment expenses for loss. Premiums for reinsurance ceded, unpaid losses, and recoverable adjustment expenses are estimated consistently with the fundamental policies and terms issued in the reinsurance contract.