Facultative Reinsurance: What Is It?

A primary insurer buys facultative reinsurance to cover a single risk or a block of risks in its business book. Reinsurance comes in two forms: treaty and facultative. Treaty reinsurance is a long-term coverage arrangement, while facultative reinsurance is a one-time transaction.

Facultative Reinsurance Process

An insurance company enters a reinsurance contract with a ceding company to transfer risk for a fee. The insurer may include this fee in the policy premium. The primary insurer can cede specific or block risks to the reinsurer. Reinsurance contract types determine whether the reinsurer can accept or reject individual or all specified risks.

Facultative reinsurance lets the reinsurance company evaluate risks and accept or reject them. Brilliant customer selection determines reinsurance company profitability. The ceding company and reinsurer create a facultative certificate to indicate the reinsurer’s acceptance of a risk.

Insurance companies ceding risk to reinsurers may find facultative reinsurance contracts more expensive than treaties because treaty reinsurance covers a “book” of threats. This indicates a long-term relationship between the ceding company and the reinsurer rather than a one-time transaction. While the higher cost is burdensome, facultative reinsurance may allow the ceding company to reinsure risks it couldn’t otherwise.

Treaty/Facultative Reinsurance

Treaty and facultative reinsurance contracts can be proportional or excess-of-loss.

Treaty reinsurance covers a large portion of a class, such as an insurer’s workers’ compensation or property business. Reinsurance treaties cover all insured-written risks within treaty terms unless they exclude specific exposures.

Treaty reinsurance requires the reinsurer to carefully review the ceding insurer’s underwriting philosophy, practice, and historical experience, but not individual risks.

They are policy-specific and cover individual policies. A facultative agreement covers a ceding insurer’s risk. Each reinsurer and ceding insurer must agree on contract terms. Many reinsurance agreements cover catastrophic or unusual risks.

Faculty Reinsurance Benefits

Reinsurance protects the insurer’s equity and solvency by covering a single risk or a block of risks.

Reinsurance allows insurers to underwrite more risks without increasing solvency margins, the amount their assets exceed their liabilities, or other comparable commitments at fair value. In cases of major losses, reinsurance provides insurers with significant liquid assets.

Faculty Reinsurance Example

Imagine a standard insurance company insuring a large corporate office building. The $35 million policy leaves the original insurer liable for $35 million if the building is badly damaged. The insurer believes it cannot pay beyond $25 million.

Thus, the insurer must seek reinsurance and market testing until it finds buyers for the remaining $10 million before issuing the policy. The insurer may receive $10 million from 10 reinsurers. It cannot approve the policy without that. It can give the policy after getting the company’s $10 million agreement and being confident it can cover the total amount if a claim comes in.

Conclusion

• A primary insurer buys reinsurance to cover a single risk or a block of risks in its business book.
• Facultative reinsurance focuses more on treaty reinsurance because the company reviews individual risks and decides whether to accept or reject them.
• Reinsurance protects the insurer’s equity, solvency, and stability during unusual or major events by covering a single or block of risks.