Treaty (noun, adjective)
A treaty, as it is generally understood, constitutes an agreement between nations which is binding no matter what the circumstances, but in reinsurance the irrevocableness of the deal is now somewhat less equitable. Treaty reinsurance describes a contractual agreement between cedant and reinsurer from which the latter cannot escape, but from which the former can usually now withdraw if a rating agency declares its diminished confidence in the reinsurer's ability to retain its franchise, thereby uttering a self-fulfilling prophesy.
Treaty reinsurance is akin to dentistry. First, both are preventative in the main. Like a scrape-and-polish, treaty cover is purchased based on perceived need, rather than desire, driven by the filling versus root canal factor: the feared worst-case scenario makes some minor up-front pain tolerable. Likewise, both treaty reinsurance and dentistry allow the buyer to bite off more than otherwise he could chew.
In the same way that dentists offer a handful of appealing services such as whitening, reinsurers sometimes offer treaties which insurers really do want. Consider a simple expense ratio deal to help an insurer reporting under US GAAP. A treaty, technically priced, might require a rate on line of 5% to cover the risk transfer. The insurer, concerned about his expense ratio, may agree to pay 8%, but with a commission payable by the reinsurer of 37.5% of ceded premium. The insurer's net premium income falls; so too do net expenses, since commission under GAAP is merely a negative expense. That forces expense ratios dramatically downward (hopefully allowing the cedant to meet a corporate objective and be rewarded with a tidy bonus). It is just one way that creative treaty underwriting can perform a magical makeover for cedants which is as dramatic as dental bleaching.
It is not the norm. Most treaty insurances and dental treatments seem punitively expensive unless they are triggered or essential. Meanwhile, treaty reinsurers have something in common with dentists. No school child grows up wanting to be a reinsurer, nor is dentistry a common aspiration among the imaginative young. It is chance and the pursuit of significant earnings which sometimes push otherwise creative individuals into the extraction room or the treaty office. However, when reinsurance capacity falls short, new reinsurers appear much faster than the dentist factory can manufacture new polish-and-drill men.
Proportional or excess?
Just as dentists provide both maintenance services and emergency work, treaty reinsurance comes in two basic types: proportional and excess of loss (the latter occasionally but aptly misunderstood as 'excessive' loss). Both sorts of treaty require the reinsurer to accept risk related to multiple individual insurance policies, possibly tens of thousands of them. However, in the case of proportional business the reinsurer accepts the risk at a price specified by the original insurer. For better or worse, the reinsurer typically has little recourse to interfere with the price charged.
The situation is different with excess of loss covers, where the reinsurer accepts only a specific layer of risk arising from a specified portfolio, usually a specific amount 'excess of' another amount. In theory the underwriter has complete pricing control, but that supremacy is nowadays delegated to risk modelling software. These fancy programmes determine a likely loss to a specific treaty if a theoretical event occurs, thereby helping reinsurers to find the otherwise elusive 'right price' (or at least the minimum). Then, when real losses happen, the modellers redevelop their software to reflect new experiences, hoping that future outputs will better reflect the real potential losses. This practice (V point X-ing) is like insurers deciding how much treaty reinsurance they need based on their largest historical loss, then revising their opinion when something burns through it.
Reinsurance lexicographers happily discuss the origins of the word treaty for hours. Some say it was first used in Lloyd's, when an enterprising trader wrote an arbitrage deal so sweet he whistled and declared, "she's a real treat." Others say that the wordings which typically accompany the contract (or, in practice, follow an average of 127.4 days after conclusion) are so lengthy that each is considered a 'treatise'.
Still others say the usage relates to the arcane English legal concept of 'invitations to treat'. These are the non-binding prices which shopkeepers display, inviting consumers to treat themselves, by buying the goods. (The same concept allows internet retailers to advertise £3 televisions but wriggle out of the deal later on.) The relationship between 'invitation to treat' and 'treaty' is said to arise from the treaty capacity once granted by eager marine reinsurers. So large and cheap was their treaty product that it was viewed as an 'invitation to invite to treat'. The treaties allowed hull underwriters to offer uneconomic prices and still report profits. It is just one of the possibilities that treaty reinsurance buyers love to sink their teeth into, but like the dentist's drill should be treated with care indeed.