DEFINITION of ‘Commutation Agreement’
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.
INVESTOPEDIA EXPLAINS ‘Commutation Agreement’
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.