Reinsurance and its effect on reserves, capital and risk transfer
What the domain tests
This domain tests how reinsurance changes the gross reserve, the recoverable asset, the net capital position, and whether risk has genuinely been transferred.
Core rules
- Proportional treaties (quota share, surplus) share premiums and claims by a fixed proportion. Non-proportional treaties (excess of loss, stop loss) respond above a retention, subject to limits and reinstatements.
- Reinsurance recoveries are assets. Their value depends on the reinsurer's credit quality, collateral, and contractual disputes. Expected credit loss = recovery × probability of default × loss given default.
- A treaty must transfer significant insurance risk to receive accounting and capital recognition; finite or deposit-like arrangements may be accounted for as deposits.
- Reinstatement premiums, sliding-scale commissions, profit commissions, and aggregate deductibles affect the net result and should be modelled explicitly.
Worked example
Gross reserves are ₹1,000m. A 30% quota share is ceded, so the gross recovery is ₹300m. The reinsurer has a 2% probability of default and 50% loss given default. Expected credit loss = 300 × 0.02 × 0.50 = ₹3m. Net reserve = 1,000 − 300 + 3 = ₹703m. If the treaty instead had no collateral and a 10% default probability, the credit loss would be ₹15m and the net reserve ₹715m.
Traps
Assuming every ceded rupee reduces capital one-for-one; ignoring reinstatement premiums; valuing recoveries gross of bad debt; misclassifying a treaty as proportional when it is really excess of loss; ignoring risk transfer tests; failing to reflect reinsurance in unearned premium and deferred acquisition cost calculations.