Reinsurance companies effectively provide insurance to other insurance companies, with the principal aim of mitigating unusually high losses. Profit commissions in reinsurance refer to profit-sharing payments that the insurance company pays out to reinsurance companies. Profit commissions are not guaranteed but stem from an agreed-upon formula between the insurance company and the reinsurance company.
Although profit commission calculations can take a number of forms, a basic formula follows this pattern: Profit Commission = (Reinsurance Premium - Expense - Actual Loss) x Profit Percent. The insurance and reinsurance company must find mutually acceptable numbers, such as a fixed percentage of the reinsurance premium for reinsurer expenses and profit percent. Many contracts include sliding scales for losses that lower or increase profit commissions.
For simplicity, assume an insurance company secures reinsurance for a single policy. The insurance company pays a reinsurance premium of $1,000 for one year. The insurance and reinsurance companies agree to a 25 percent expense allowance and settle on a 30 percent profit. If the reinsurer uses the full 25 percent expense allowance and a $100 actual loss occurs, then the profit commission calculation appears as follows:
($1,000 - $250 - $100) x 0.30 = $195
Assume an insurance company secures a reinsurance policy with an annual premium of $125,000, with an expense allowance of 15 percent and a 45 percent profit in the event of no losses. If a loss of $10,000 occurs, the profit percentage drops to 38 percent. The reinsurance company’s actual expenses equal only 13 percent, rather than 15 percent, and a $10,000 loss occurs. In this case, the calculation requires more steps or a more complex equation. By determining the expense allowance first, the equation remains simpler.
Expense Allowance = $125,000 x 0.13 = $16,250
Profit Commission = ($125,000 - $16,250 - $10,000) x 0.38 = $37,525
A number of factors complicate what appears as a straightforward math problem. Reinsurance typically pays only after the insurance company pays out on a claim. Insurance claims, depending on the size and the complexity of the claim, can take years to settle. The reinsurance contract may deal with the liability by pushing it to the following year or by leaving it open on the books until the insurance company settles the claim, which complicates the ongoing math. Contracts between insurance companies and reinsurance companies rarely involve a single policy or even type of policy, so the profit commission formula must either take into account a broad range of variable risks or use a sliding scale to accommodate actual losses.
