Commutation

Introduction

Commutations have been applied to reinsurance contracts since they were first written many centuries ago. However, most insurance and reinsurance professionals don't fully understand commutations, which are complex agreements to "commute" or terminate obligations of the parties to a reinsurance contract. This article helps take the mystery out of commutations by explaining their purpose, steps in the commutation process, and specific commutation contract wordings. The last section provides a case study that illustrates the benefits of commutations to both ceding companies and reinsurers.

Basics

The following definition of "commutation" is used throughout this article:

Commutation:

A commutation is an agreement between the parties to a reinsurance contract whereby all obligations under the reinsurance contract are terminated.

It is important to distinguish a commutation from a contract cancellation. A commutation terminates all obligations under the reinsurance contract. By contrast, when a reinsurance contract is cancelled, the parties to the contract remain responsible for fulfilling certain premium and loss payment obligations.

Abstract

A large number of reinsurers and insurers are interested in finalizing obligations made under reinsurance contracts issued in past years. This can be accomplished through a technique known as commutation. Those involved with negotiating commutations-feel the number has increased significantly in recent years.

Commutations are not well understood by many insurance and reinsurance professionals.

The most significant obligation is the reinsurer's ongoing responsibility for paying outstanding losses that occurred while the contract was in effect.

In a commutation, the reinsurer pays the ceding company in exchange for a release of the reinsurer's obligation to make ongoing payments on losses. (Under certain circumstances, the ceding company pays the reinsurer in a commutation, although this is much less common.) Therefore, for a sum of money, the ceding company reassumes responsibility for outstanding losses that were previously ceded and assumes responsibility for any losses yet to be ceded to the reinsurer under the reinsurance contract. The requirement for the parties to account for premiums and losses ends at the time of the commutation.

The specific terms of a commutation are negotiated between the ceding company and the reinsurer. Underwriters, actuaries, claims experts, accountants, and lawyers are usually involved. Underwriters usually coordinate the activities and identify the business reasons for the commutation; actuaries and claims experts usually...