Commutation Agreement

A commutation agreement is a reinsurance agreement in which the reinsurer and 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.

Insurance companies use reinsurance in order 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 of time.

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. In order to exit the reinsurance treaty it must negotiate with the reinsurer, with the 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 in order to avoid government regulators becoming involved.

Commutation agreement negotiations can be complicated. Some types of insurance claims are filed a long time 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.

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 present value of expected future paid losses (using an after-tax discount rate appropriate to the company and line of business)
  

• The present value of the tax benefit related to the unwinding of the federal tax discounted reserves (using the IRS prescribed discounting procedure)
  

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.