Commutation Agreement

What Is a Commutation Agreement?

A commutation agreement is a reinsurance agreement in which the reinsurer and the ceding company agree on the conditions under which all obligations for both parties in the agreement are discharged.

A commutation agreement includes the methods for valuing any claims or outstanding charges, and how any remaining losses or premiums are to be paid.

Understanding Commutation Agreements

Insurance companies use reinsurance to reduce their overall risk exposure in exchange for a portion of the premium. Reinsurers are responsible for the risks that are ceded, with coverage limits determined in the reinsurance treaty. Reinsurance contracts can vary in length but may last for extended periods.

Sometimes an insurer — also called the ceding company — decides that it no longer wants to underwrite a certain type of risk and that it no longer needs to use a reinsurer. To exit the reinsurance treaty, it must negotiate with the reinsurer, with negotiations resulting in a commutation agreement.

The insurance company may also consider exiting the reinsurance treaty if it determines that the reinsurer is not financially sound and thus poses a risk to the credit rating of the insurer. The insurer may also estimate that it is more capable of handling the financial impact of claims than the reinsurer.

On the other hand, the reinsurer may determine that the insurance company is likely to become insolvent and will want to exit the agreement to avoid involvement from government regulators.

Commutation agreement negotiations can be complicated. Some types of insurance claims are filed long after the injury occurs as is the case with some types of liability insurance. For example, problems with a building may only appear years after construction. Depending on the language of the reinsurance treaty, the reinsurer may still be responsible for claims made against the policy underwritten by the liability insurer. In other cases, claims may be made decades later.

Pricing a Commutation Agreement

There are a number of factors to consider when an insurer and reinsurer put a price to their commutation agreement. Usually, calculations begin with a determination of the cost to the reinsurer of not commuting. This cost is the difference between the following two quantities:

The cost of the commutation is calculated by subtracting from the cost of not commuting the value of the tax on the underwriting gain or loss generated by the commutation. This is the result of the takedown in reserves and payout of the final cost of commutation. This final cost of commutation represents the break-even price and reflects no loading for risk or profit.