Facultative Reinsurance

Facultative reinsurance is the insurance cover purchased by a primary insurer. It helps to cover a single or a block of risk assumed by a primary insurer. It is like a one-time agreement for reinsurance. Exposure of the primary insurer is offered to the reinsurer in a single transaction—submission and acceptance, required on each risk that is being reinsured. Negotiation is possible for each of the risks assumed. The reinsurer is not obliged to accept every risk that the primary insurer seeks to reinsure.

Summary

• Facultative reinsurance is a type of reinsurance cover bought by a primary insurer to cover a single or a block of risk.
• There is scope for a reinsurance company to review individual risks and negotiate on them.
• It ensures solvency on the risks appearing in the books of the primary insurer by way of transferring an individual or a block of risks to a reinsurer.

Frequently Asked Questions (FAQ)

How does a facultative reinsurance happen?

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• The primary insurance company opting for a reinsurance deal on its book risks is called the ceding company.
• It goes for reinsurance to release some portion of its risk in return for a charge.
• Ceding company surrenders a single or a block of risk to the reinsurer.
• The reinsurer can negotiate on every risk he shall assume. A separate deal is required for all the risks that the reinsurer assumes.
• Facultative reinsurance allows the reinsurer to analyse individual risks and determine the terms of the agreement.
• The ceding insurer and the reinsurer make a facultative certificate in return for the risk accepted by the reinsurer.
• It provides flexibility to reinsure select risks from a primary insurer's books, which otherwise would not have been reinsured.

Example of facultative reinsurance agreement:

Consider a standard insurance company. It issues a policy on a huge warehouse of an online retailer. The policy amount is AU$50 million. This means the primary insurer has a potential AU$50 million in his books if the warehouse gets badly damaged. The primary insurer believes that it would not bear a hit of AU$50 million in case of loss. So, he looks up facultative reinsurance to cover this risk. It can either get it reinsured with a single insurer or get pieces covered by multiple reinsurers. The reinsurers have a right to assess the risks they will assume and choose to accept or reject them.

How is facultative reinsurance different?

There are two kinds of reinsurance agreements- facultative and treaty.

Facultative reinsurance- 

• It has a focused approach and only covers specific risks from ceding the company's books.
• The reinsurer must agree to manage and accommodate a single risk or a block of risks.
• The expense is much more, and it is a costlier option for ceding company.
• It is often the simplest way to obtain reinsurance in a tailor-made fashion, depending on specific circumstances.
• The reinsurance certificate is written on a policy-specific basis.
• There is a mutual agreement and understanding on each risk assumed amongst both parties involved. Such agreements often help to cede the company to remain safe from unusual, unexpected risk exposures.

Treaty reinsurance-

• On the other hand, treaty reinsurance is for a book of risks.
• The surrendering organisation reinsures the entire risks required to be covered in one go.
• Treaty reinsurance agreements are for a more extended period.
• It often covers a particular part of an insurer's entire insurance business.
• The agreement makes the reinsurer assume all risks that fall within treaty terms.
• There is no scope for reviewing individual risks, but there is a review of the underwriting philosophy based on the historical experience of insurers.

Both reinsurance contracts can be made to cover risks on a proportionate or excess-of-loss basis. A combination of both criteria is also usually allowed.

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Pro-rata reinsurance or proportional reinsurance is one where premium and losses are shared proportionally. The reinsurer pays a ceding commission to reimburse for expenses associated with the policy. It is quite easy to administer and offers good protection against high frequency and severity losses.

In the excess loss type of reinsurance policies, the ceding company retains some of the liability for losses. It pays a fee to the reinsurer for covering that retention. Coverage is generally subject to an upper limit. Excess of loss arrangements has cheaper reinsurance premiums and costs of administration.

What are the benefits of facultative reinsurance?

• It gives the ceding company more security and solvency in unusual or major events.
• It makes available substantial liquid assets available for insurers in case of unexpected losses.
• The risks are considered on a one-to-one basis and not as a whole.
• The primary insurer gets a competitive edge within its chosen business, whose risks are reinsured.
• It offers freedom to choose any risk as accepted or declined for reinsurance.
• Ceding company may take up a proportional agreement to protect facultative reinsurance.
• The insurer gets a lot of other benefits from specific knowledge of a business with the facultative reinsurer.
• It can become a steppingstone to build new relations with other insurers in the market.

What are the disadvantages of facultative reinsurance?

• There is no guarantee about the successful placement of risks for the insurer.
• It is a lot more expensive compared to treaty reinsurance.
• It requires administration even after reinsurance.
• The ceding company must disclose details of risks and losses to the reinsurer.
• There is a possibility of an error factor in cases of hurried facultative placements.
• The commission reimbursement to the primary insurer is generally low.
• Reinsurers are often at the beneficial end of the agreement. They obtain business on advantageous terms.
• Unless risk placement is complete and documented, the risk is not shifted from the ceding company's books.
• Facultative reinsurance, when of a proportional type, is often very complicated.
• Subsequent amendment of terms leads to the cession of the deal.
• Each risk assumed needs to have fresh documentation.