When dealing with proportional reinsurance; the item of profit commission is one that cannot be missed. In writing business, cedants incur costs, such as administration costs, agency fees and the like. To compensate the cedant for these costs, reinsurers offer a commission on the premium ceded by the cedant.
For reinsurers however, the profitablitly of a treaty is also important and simply offering a ceding commission does not encourage the cedant the write good quality risks. As a way of incentivizing, reinsurers offer an additional commission to the cedant inform of what is known as a “profit commission”. We can look at it as a bonus or 13th cheque from the reinsurer to the cedant for a profitable treaty.
Profit commission is the commission over and above the ceding commission offered by the reinsurer to the cedant to encourage good quality underwriting and profitability of the treaty.
So When and how is profit commission calculated? The concept of profit commission is only used when dealing with proportional treaties. i.e. Quota Share & Surplus treaties and only for those treaties with fixed commissions and not sliding scale commissions. (for more on commissions, check out my earlier article on pricing of proportional treaties). The Reason PC’s as they are commonly referred to are not used under the sliding scale system is because, this system is already self-rewarding and at the same time self-penalizing. If the treaty preforms well, then a higher commission is offered where as if the treaty performs poorly, then a lower commission Is offered with adjustments done at the end of the year.
At the end of the year, if a treaty is profitable i.e income > expenses, the reinsurer will offer a percentage of that profit back to the cedant as a reward/a token of appreciation for the good performance. The schedule of the Treaty slips/cover notes usually states the percentage of the PC. The treaty slip also has a profit commission clause which shows how the calculation of the profit commission should be done.
The Difference between Income items and outgo items is what gives the profit and it’s on this that the profit commission is calculated using the percentage specified in the treaty schedule. The items used as income and the outgo in the PC statement include.
Items of Income;
-Premiums for the current year
-Outstanding loss reserve at the end of the previous year (Loss portfolio withdrawal from previous year=Loss portfolio entry for current year)
-Unearned premium reserve at the end of the previous year (Premium portfolio withdrawal from previous year= Premium portfolio entry for current year)
Items of outgo;
-Commissions paid by the reinsurers during the course of the year.
-Claims paid during the current year.
-Outstanding loss reserve at the end of the current year (Loss portfolio withdrawal at the end of current year).
-Unearned premium reserve at the end of the current year (Premium portfolio withdrawal at the end of the current year).
-Reinsurers administration costs for example management expenses.
-Any loss/deficit from the previous year carried forward to extinction or for a given period depending on the treaty agreement
Profit = Items of income- Items of outgo; Profit commission = profit * % stated in the schedule
When calculating profit commission for a given class of business, it is very important for the cedant to first ascertain the accounting period to which that class of business falls under. i.e. either Underwriting year basis or Accounting Year Basis (I will talk about these in a later article). Why? This is because each accounting period has a different way in which the income and outgo items especially premium and loss reserves are treated, so without understanding this, there is a possibility that the cedant may calculate a wrong PC and possibly a low value for which reinsurers will be more than happy to pay.
Without further ado lets, take a look at an example to through more light on how profit commission is calculated for the different accounting methods.
Example 1- AZ insurance company has the following results for fire portfolio and would like to calculate its profit commission for the 2016 treaty year.
Outstanding Loss reserves at the end of the previous year- 650,000. Unearned Premium Reserve at the end of the previous year 1,500,000.00. Management Expenses were at 7.5%. Unearned premium Reserves at the end of the current year were at 50%, fixed commission to cedant was at 30% and profit commission agreed at 25%
The Reinsurance Premium for 2016 was 5,000,000. Total Reinsurance claims paid were 2,000,000, Reinsurers outstanding losses at the end of the current year = 600,000 and Deficit carried forward from 2015 was 40,000.00.
The unearned premium reserve at the end of the year would be 50%*5,000,000= 2,500,000.00.
The Profit commission will therefore be calculated as per the table below
A worthy point to note from the above example is; had the treaty had made a loss instead of a profit, then this loss would be carried forward to the forthcoming year’s PC statement.
I indicated earlier that the nature of the accounting method for a given treaty determines how the Profit commission will be calculated i.e. clean cut or underwriting year basis. So when dealing with the clean cut accounting, instead of premium and loss reserves, we have portfolio entries and withdrawals. This is method of accounting deals with portfolio movements and all accounting operations are done within the same treaty year.
The Premium and Loss Portfolio entries are treated as an income whereas the premium and loss portfolio withdrawals are treated as an outgo in the profit commission statement.
The treaty will usually state how portfolio entries and withdrawals would be treated. An Example of how this is stated is;
"Incoming/Entry: Premium- 35% less commission, Losses- 90% and Outgoing/Withdrawals: Premium- 35% less commission, Losses- 90%
what this means is that the 35% of the premium income from the previous year less the commission at that time will be transfered to reinsurers of the current treaty year and for this, the reinsurers of the currrent treaty year will be responsible for 90% of the outstanding losses from the previous year. Ideally, The Portfolio entries of the current year should correspond to the portfolio withdrawals of the previous year. For example, if in 2015 Az Insurance company ceded reinsurance premium of 2,000,000 and received commission of 35% and also had outstanding losses of 1,000,000 at the end of the year, when preparing the profit commission for 2015, the Premium Portfolio withdrawal would be= 35% of 2015 premium-commission= (35%*2,000,000) -(35%*2,000,000*35%)= 455,000.00 and the Loss Portfolio withdrawal will be = 1,000,000 *90%= 900,000.00. In our 2016 PC statement, these items will be treated as the portfolio entries.
When calculating the portfolio withdrawals, the premium and loss figures used should be those of the current year.
Important Points to note;
1.Profit commission is only used when dealing with proportional treaties.
2.It does not apply where sliding scale commission is used.
3.The method of accounting is important when calculating profit commission i.e underwriting year basis or clean cut basis.
4.The treaty cover note will usually state what the percentage of profit commission is. There is also a clause in the treaty, "profit commission clause" that states how it should be calculated.
5.The Cedant when preparing the profit commission statement should take care to ensure that the provision of outstanding claims is accurate.
In my next article, I will be throwing more light on the accounting methods used i.e. Clean Cut basis and Underwriting year basis and how they operate.
