Obligatory Reinsurance: Definition, How It Works, Types, Pros & Cons

What is obligatory reinsurance?

Obligatory reinsurance — also called an automatic treaty — is an agreement that requires an insurer (the cedent) to cede, and a reinsurer to accept, all policies that meet a predefined set of criteria. Once a risk falls within the treaty’s scope, it is transferred automatically to the reinsurer, often without individual negotiation or prior notification.

How it limits financial risk

Reinsurance is “insurance for insurers”: it shifts portions of an insurer’s risk portfolio to a reinsurer in exchange for a share of premiums. By moving a book or class of business off the primary insurer’s balance sheet, obligatory reinsurance:
* Reduces the likelihood that a single large loss or adverse event will bankrupt the cedent.
* Smooths insurers’ loss volatility and stabilizes capital requirements.
* Provides a predictable, ongoing mechanism for risk distribution when arranged as a treaty.

Pros and cons

Pros
* Predictable, steady flow of business to the reinsurer and consistent protection for the cedent.
* Economies of scale — transferring a portfolio is typically cheaper than negotiating individual facultative placements.
* Facilitates longer-term strategic relationships between insurers and reinsurers.

Cons
* Automatic acceptance removes selectivity, increasing the reinsurer’s exposure to concentration or unexpected accumulations of loss.
* If the reinsurer becomes insolvent or undercapitalized, the cedent may become fully responsible again for ceded risks.
* Ambiguous treaty language or poorly defined covered risks can lead to disputes or make unwinding the arrangement difficult.

Fast fact: over-reliance on reinsurance was a major factor in the collapse of Mission Insurance in 1985, illustrating the systemic risk when parties do not adequately assess counterparties and exposures.

Facultative vs. treaty reinsurance (and how they relate to obligatory arrangements)

• Facultative: Covers individual risks or specific contracts. Each risk is proposed and accepted or declined by the reinsurer, though hybrid arrangements exist that give the cedent the option to cede individual risks regardless of reinsurer preferences. Facultative contracts may be made obligatory for specific risks if the parties agree.
• Treaty: Covers a class or portfolio of risks for a set period. Treaty reinsurance is typically the form used for obligatory arrangements because it automatically binds all risks within the agreed scope.

Contract structures: proportional vs. non-proportional

• Proportional (pro rata): The reinsurer receives a proportional share of premiums and, in return, pays the same proportion of losses. The reinsurer may also reimburse the cedent for acquisition and administrative expenses.
• Non-proportional (excess of loss): The reinsurer pays only for losses that exceed a specified retention or attachment point during a defined period. This can be structured per risk or on an aggregate basis for a class of business.

Key considerations when negotiating obligatory reinsurance

• Precisely define which risks, classes, and timeframes are covered to avoid ambiguity and disputes.
• Perform thorough due diligence on the counterparty’s financial strength, underwriting standards, and portfolio composition.
• Agree clear notification, reporting, and claims-handling procedures, including how and when ceded risks are reported.
• Set retention levels, limits, attachment points, and any exclusions or special terms.
• Include provisions for review, renewal, and termination to manage changing exposures and market conditions.
• Consider catastrophe aggregation, accumulation controls, and concentration risk to prevent unexpected liabilities.

Key takeaways

• Obligatory reinsurance automatically transfers predefined classes of risk from cedent to reinsurer, creating predictable protection and steady business flows.
• It reduces volatility and supports capital management but also removes reinsurer selectivity, which can increase systemic and counterparty risk.
• Clear contract terms, strong counterparty due diligence, and appropriate proportional/non-proportional structures are essential to manage the benefits and drawbacks of obligatory treaties.